With many situations in life where there are two directly opposing opinions, each side believes their way to be the best, and this is certainly true of passive and active management in stock market investing. Proponents of passive management, also referred to as index investing, generally believe that the market can’t be beaten and therefore portfolio managers don’t make the decision as to which securities to buy or sell. Instead they copy an index by buying the same securities that are included in a particular bond or stock market index. Active managers, on the other hand, attempt to beat the market as measured by a chosen index or benchmark, such as the Standard & Poor’s 500 or the Russell 1000, that gauge the performance of blue chip stocks. The ultimate goal of active management is to outperform the index for a particular fund by taking into account prevailing market trends, political and other current events, the economy and factors such as earnings growth relating to individual companies.
Some of the advantages of passive management include low operating expenses and no decision making required by either the investor or fund manager. Active management advantages include being in the position to take defensive measures if deemed necessary and the possibility of higher-than-index returns. Proponents of active management generally agree that there is a certain sense of satisfaction when making decisions based on prevailing market trends, along with good judgment and experience – especially if those decisions have lucrative results.
Disadvantages of passive management include the fact that performance is always dictated by index, meaning that investors must be satisfied with market returns, plus the inherent lack of control dictated by being passive thereby preventing defensive measures if it appears that stock prices are heading for a dip. Active management disadvantages include higher operating expenses, the risk of bad decision making with the resultant reduction in returns, and the possibility of a fund manager’s style being out of sync with market trends which could also negatively impact on returns.
While Wall Street players may continue to debate the merits of passive versus active management, with each taking a turn at being the favored trend from time to time, investors may do well to take a long-term view, remembering that both passive and active managers are selecting investments from the same pool of equities, but just managing them differently.
