Active vs. Passive Investing: Which Approach Offers Better Returns?

 The past decade, index-style investing has become the strategy of choice for many investors who are satisfied not trying to beat market returns. But does active investing become more appealing for high net worth investors, who have opportunities that small investors do not?

While actively managed assets can play an important role in a diverse portfolio, large investors often do best using passive investments for the bulk of their holdings. Active investing, can nonetheless be useful with certain portions of the portfolio, such as those invested in illiquid or little known securities, or holdings tailored to a specific purpose such as minimizing losses in a down market.

“Passive” Strengths

Even for wealthy investors, passive holdings have a strong appeal. The big issue still applies. That’s the issue of whether you believe in trying to beat the market or whether you believe in minimizing costs.

Passive, or index-style investments, buy and hold the stocks or bonds in a market index such as the Standard & Poor’s 500 or the Dow Jones Industrial Average. A vast array of indexed mutual funds and exchange-traded funds track the broad market as well as narrower sectors such as small-company stocks, foreign stocks and bonds, and stocks in specific industries.

Among the benefits of passive investing:

• Low expenses — since there is no need to analyze securities in the index
• Good transparency — because investors know at all times what stocks or bonds an indexed investment contains
• Tax efficiency — because the index fund’s buy-and-hold style does not trigger large annual capital gains tax.

Actively managed investments charge higher fees to pay for the extensive research and analysis required to attempt to outperform their benchmarks.

“Active” Advantages

Many financial advisors recommend actively managed investments for significant portions of their clients’ portfolios. Active management includes mutual funds and exchange-traded funds, as well as portfolios of stocks, bonds and other holdings managed by financial advisors. Among the benefits they see:

• Flexibility  –  because active managers, unlike passive ones, may not be required to hold specific stocks or bonds
• Hedging  –  the ability to use short sales, put options, and other strategies to manage against losses
• Risk management  –  the ability to get out of specific holdings or market sectors when risks get too large
• Tax management – including strategies tailored to the individual investor, like selling money-losing investments to offset taxes on winners

 Selection Strategies

The choice between active and passive investing can also hinge on the type of investments one chooses.

Passive management generally works best for easily traded, well-known holdings like stocks in large U.S. corporations, because so much is known about those firms that active managers are unlikely to gain any special insight.

However in certain niche markets, like emerging-market and small-company stocks, where assets are less liquid and fewer people are watching, it is possible for an active manager to spot diamonds in the rough.

It’s a complex subject, especially for high net worth investors with access to hedge funds, private equity funds, and other alternative investments, most of which are actively managed.