(US News) -- There are two main camps when it comes to funding management: active funds and passive funds. But when it comes to active versus passive investing, which is the best investing strategy may be less clear than either camp would have you believe.
"Active versus passive investing strategies have often been framed as an all or nothing proposition," says Kent Insley, chief investment officer at Tiedemann Advisors.
But this needn't be the case. "We believe that combining active and passive management is the best way to construct a portfolio, focusing active strategies in areas where they are most likely to succeed," he says.
To determine which strategy to use and when you need to understand when each one excels and falls short.
Active Vs. Passive Investing
USE ACTIVE INVESTING IF:
USE PASSIVE INVESTING IF:
You're willing to pay more for potentially higher returns.
You want the lowest possible cost.
You're concerned about risk or want downside protection.
You don't believe it's possible to beat the market.
You have a specific investment objective (such as income) beyond market performance.
You're a hands-off investor.
You're worried about needing to withdraw in a downturn.
You have a long-term time horizon.
You're investing in a sector with no investable index or where greater oversight is needed.
Taxes are a concern.
As the name implies, active investing is the active selection of investments that are thought will outperform going forward. Active investors believe it's possible to beat the market by overweighting good prospects and underweighting bad ones. Passive investing takes the opposite view: Passive investors don't believe it's possible to outperform the market consistently, so they prefer instead to take a back-seat approach by just investing in the market itself.
"If you want exposure to the biggest companies in the U.S., you can get that very easily and inexpensively through a passive or passive mutual fund," says Brian Kraus, a certified financial analyst and head of investment consulting at Hartford Funds. But if you want only those biggest companies with a strong dividend track record, you'd need an actively managed fund.
Likewise, "while index funds have proliferated and now offer exposure to a wide variety of markets, there are still many markets and investment strategies for which there is no investable passive index," Insley says. And there are some areas where experts say passive investing simply can't suffice, such as fixed income or international markets. In these areas, passive approaches can result in adverse concentrations.
Active Investing: The Benefits and Drawbacks
Being able to tailor the investing experience to more specific goals is one benefit of active investing. "For example, an active fund might have a dual mandate of above-average income with a secondary objective of long-term capital appreciation," says Andrew Crowell, vice chairman of wealth management at D.A. Davidson & Co. in Los Angeles. This can help investors achieve an outcome more in line with their needs and goals.
Active managers can also turn an eye toward risk mitigation. Passive investors are at the mercy of the index: When it's up, they're up; but when it's down, they're just as far down. Active managers can shelter their investors from some of that downside with more strategic investment selection. The flip side to that is you may not rise as high as the index either. Such is the price of having a smoother ride.
"The goal of active investing is to outperform on a risk-adjusted basis and earn the fee the investor is paying to get a more nuanced exposure," Kraus says. When they are successful in this regard, active funds can be lucrative investments. But earning their fee can be a tall order for active fund managers.
The higher cost of active management is perhaps its greatest downfall. This can create a hurdle rate for outperformance, Crowell says. Active managers need to not only outperform the market, they need to outperform it by more than the fee they charge.
On top of this, the more frequent buying and selling in active funds can result in higher capital gains distributions, which may raise the hurdle rate even higher. Finding an active manager, who can consistently perform above and beyond all these hurdles, is no small feat. Thus the active investor must do more homework in finding an active manager who can also get a passing grade on his homework.
Passive Investing: The Benefits and Drawbacks
There's a reason passive investing has gained a loyal following, but it's by no means perfect. Investors who prefer a more tried-and-true and hands-off approach to investing gravitate toward passive investing.
With passive investing, "what you see is what you get," Kraus says. It's predictable in that you know you're going to own whatever companies are in the index you're tracking. It's also more predictable in terms of cost.
That's because indexes have few annual changes; passive funds will have lower turnover and fewer capital gains distributions, which means a lower tax bill for investors.
Passive funds also have the benefit of keeping you fully invested at all times. Active managers may keep a portion of the portfolio in cash to capitalize on future opportunities. Since passive managers aren't trying to time the market, there'll be no cash drag on the portfolio.
Despite these lower cost hurdles, passive funds do fall behind their active brethren in a few regards. Most notably, there's no downside protection or customization. Your passive fund can't protect you from a market slide by picking the best of a falling bunch. Nor can it cherry-pick only the highest dividend payers of a given market to help you reach your income goals.
Market capitalization-weighted indexes can even inadvertently increase your risk, Crowell says.
"As markets and sectors and industries move up at price, their respective weightings in the index increase as well, which means that each new dollar invested is allocated disproportionately toward the most expensive sectors and less toward the least expensive," he says.
This is why market capitalization strategies are "the antithesis of value investing," Kraus says.
They're also backward-looking: "The problem with passive investing is a passive investor is unintentionally continuing to buy what worked well yesterday without a view toward what could work well tomorrow," he says.
Active Vs. Passive Management: Which Is Right For You?
Ultimately, the biggest question to ask yourself is which strategy will let you sleep well at night, Crowell points out.
Because neither will get you to your goals if you abandon ship prematurely.