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Active investing versus passive investing... And the winner is...

Active investing versus passive investing... And the winner is...

| August 01, 2016

"Competition is always a good thing. It forces us to do our best. A monopoly renders people complacent and satisfied with mediocrity." - Nancy Pearcy

Should we be taking sides?

Much of the argument between active and passive investment management is based on the efficient market hypothesis (EMH). The basic premise is that it is not possible to outperform the market at different levels, especially due to mispriced securities. According to the EMH, outperforming the market is an anomaly and can't be consistently achieved. So, is active management a fool's enterprise? Is passive always going to win? The answer isn't so simple. Let's take a look at both sides.

Active management

  • Believes EMH is false
  • Seek to out-perform benchmark
  • Higher costs
  • Flexible objectives

Active management is just as it sounds. Investment managers actively manage their portfolios. They buy and sell based on their objectives and research; some strategic, some tactical.  Active managers seek to outperform their benchmark either in raw performance, or through reduced risk. many use the S&P 500 or Barclays Aggregate. Raw out-performance based solely on numbers is hard to do in the short term. Often managers seek a risk-adjusted basis, usually over certain time periods or business cycles. Reducing risk of loss more than sacrificing the benefit of gain can be powerful in the long run, specifically over a market cycle or longer. Active managers do not believe in the EMH. The cost associated with an active manager may not be as important to an investor if the manager is performing well. This is where cost is absolutely important - in the absence of value.

Passive Management

  • Believes the EMH is true (at least to some degree)
  • Cost sensitive
  • Seek to match the index
  • Rigid portfolio contraints

Passive management on the other hand is typically achieved through the purchase of index funds or exchange traded funds. Since passive managers follow the EMH, they do not believe they can outperform the market and desire to achieve returns through asset allocation. Passive management is extremely cost-sensitive since all costs pull fund performance further below the index. The best way to win with indexes is by having the right indexes in the portfolio and having the lowest possible cost. Any cost associated with these investments has a direct drag on the performance of the account. 

The good and the bad

We could write for days on the merits of both schools of thought. However, the purpose of this article is to help us understand the importance of understanding which philosophy we are using. We have seen it all over the board, active only, blended, passive only… At Engage Advisors, LLC, we work towards a healthy, risk adjusted return by using a disciplined strategic asset allocation along with careful manager selection for the actively managed funds we utilize.  We do use both actively and passively managed funds. However, we primarily utilize active management, spending both time and resources on the due diligence of fund selection. Read more about our investment philosophy here.