Passive vs. Active Portfolio Management

When considering portfolio management styles, investors are typically faced between choosing an active or passive approach based on their long-term financial goals as well as their ability and willingness to take on risk exposure. An active approach, as the name suggests, requires a significantly higher degree of monitoring and attention, while a passive approach requires less maintenance and should be relatively stable in the long run. There are pros and cons to each type of portfolio management approach and also requires a varying amount of knowledge and time commitment in order to ensure a successful strategy.

Active investing focuses on trying to outperform the market’s average returns by taking advantage of the short-term price movements of certain stocks and trading in and out of positions for a profit on each trade. The active approach is riskier than a long-term buy-and-hold strategy since it is attempting to time the markets and profiting off swings in price levels; however, with more risk comes a potential for higher returns. A successful active investing strategy requires an investor to take on the role of a portfolio manager to constantly monitor the markets for news and events that may present a new opportunity/risk to the current portfolio. This should be a key consideration for investors if they choose to actively manage their own investment portfolios since it will require a significant amount of time and access to resources. The advantage of this approach is that investors are able to quickly adjust to market conditions based on their preferences in order to adjust their level of risk exposure or to take advantage of short-term trends that may yield attractive investment opportunities.  One of the disadvantages of active portfolio management is the potentially high transaction costs that can be accumulated from making frequent changes to portfolio positions. Although some discount brokerage firms may lessen the impact of these costs, premium brokerages can charge quite a bit for their services and their fees can definitely eat into the return on an investor’s hard-earned dollars.

Passive investing is driven by a long-term focus in contrast to the active approach. Here, investors are no longer focused on the short-term price movements and trends, but rather on the long-term appreciation of market price levels. For the average investor, a passive approach is less risky than an active strategy, while still maintaining reasonable returns in the long run. A popular passive strategy for the equities market is to own shares of an indexed fund that tracks the performance of an index such as the Standard and Poor 500 (S&P 500). These offer good diversification across strong businesses and sectors. Another passive strategy is for investors to carefully select their own portfolio of stocks and apply a buy-and-hold mindset where they are not concerned about the short-term price movements. Investors hold their positions for a longer period since equities tend to rise in value over the long run. The advantage of the passive approach is that it allows investors a peace of mind without having to constantly stress about the short-term market movements and can be more cost effective since investors can avoid the heavy transaction fees from frequent changes to portfolio positions. One of the disadvantages of this strategy is the limited flexibility of what you can do with your portfolio since the level of risk and return strongly correlates to the overall markets. The returns earned are based on the upward trajectory of corporate profits over time and may be smaller in comparison to a successful active investing strategy. Another key point to consider is that although there are negligible transaction fees in passive investing, funds typically have a management fee expressed as the management expense ratio (MER) which typically ranges from 1-3% of the total funds under management. Investors should be wary of funds with high MERs since these management fees can also significantly impact the return on your investment.

It is common practice for investors to use both of these approaches. Keep in mind that an investor doesn’t necessarily have to choose one over the other; applying a blended strategy of both active and passive investing allows you to get the best of both worlds through a diversified approach.  It will allow their portfolio to profit from the upsides in short-term opportunities with active investments while also being defensive in downturns of a particular stock or sector by holding passive investments that are less volatile. As an investor, it is worthwhile to consider the advantages and disadvantages of each. You should always consult your financial advisor on what the most appropriate strategy and investment products are for you based on your long-term financial goals.