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Active Versus Passive Management Styles
Active Versus Passive Management Styles
By: Wilmington Trust

Ever since the first index portfolios were introduced in the 1970s, various debates have ensued over the merits of active versus passive investment management styles.

Simply put, active money managers seek to beat the market's returns as measured by a particular index or benchmark. An index is a broad measure of the market or a market sector's performance determined by the investment performance of a specific group of securities.

Index or passive investing, on the other hand, simply attempts to match the returns of a particular index or benchmark. While arguments have been made touting the benefits of one particular style over the other, it's helpful for an investor to understand the main principles of each style before determining which one - or a combination of the two - is most suitable for his or her particular situation.

Active Management
Active equity money managers use various methods in their attempt to outperform a given index. The essence of their approach is to capitalize on what they believe are pricing inefficiencies in the marketplace. They research company stocks and their prices and compare their valuation to that of the market. The majority of this analysis includes evaluating a company's past, current, and future earning capability with forthcoming business conditions, in relation to the company's past, present, and forecasted stock price. The intention is to buy a company stock when they believe it to be undervalued, and to sell or reduce when it is overvalued. Many active equity managers will also attempt to identify economic trends to help them predict which industries have the best near term prospects and avoid those with bleaker conditions.

Active bond managers attempt to outperform the bond market's returns through shrewd analysis of bond prices in relation to creditworthiness, and by anticipating changes in interest rates. While the quality of a bond issue and issuer are important factors, the key for active bond managers is in forecasting near-term interest rate movements. The reason why this is so critical is that bond prices move in the opposite direction of interest rates, and the prices of shorter-term bonds are usually less volatile than those of longer-term bonds. Therefore, active bond managers will vary the average bond maturity of their portfolio to take advantage of the price changes and add to the portfolio's total return.

Passive Management
Contrary to the active style, passive or index investing is built on the notion of efficient markets with little to no pricing inefficiencies. In basic terms, index investing seeks to match the returns of a market. Index funds use either a replication or sampling method to track the performance of their target index.

A couple of important factors to consider when comparing the two investment styles are the level of fees and the expected risk and returns. The investment decision-making process requires more time and resources for active managers, and as such, they typically have higher management fees. However, the manager's success may vary and typically has more volatile investment returns relative to the index.

Conversely, passive or index managers typically charge lower management fees for a more simplified investment process of matching the returns of an index. For the active style, the risk is more manager-driven, while for passive investing, it's more market-driven.

Given the nature of the investment styles, index investors are always fully invested to the index, meaning the portfolio will hold just about every security held in the index and little to no cash as an asset. This subjects the portfolio to market swings, which proves rewarding during market upturns, but costly during protracted market declines. Active managers on the other hand, vary the type of securities and amount of cash on hand due to their opinion on market conditions and security prices. These may, or may not, be rewarding during market upswings, but can be less costly during a market sell-off.

Investment Style

Advantages

Disadvantages

     

Active Management

Researched and informed investment decisions

Higher fees infringe on investment returns

 

Possibility of maximizing gains and minimizing losses

Manager risk increases inherent market risk

     

Passive Management

Low management and operating fees

Inflexible strategy

 

No manager risk

Total market risk

Investors recognizing the strengths and weaknesses of the two styles can combine them to balance their effects. The concept, originating with institutional investors but growing in popularity, blends the two styles and diversifies the risks.

Many studies have been performed to test whether one particular strategy has proven more successful. Conclusive evidence has not been determined to support either strategy in totality. However, it should be acknowledged that both strategies have appealing characteristics and have seen varying degrees of success based on certain economic conditions, market types, and time periods.

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.

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