Investing often sparks a debate about active versus passive strategies, leaving many investors feeling uncertain. While the term passive investing suggests a relaxed, hands-off approach, the reality is more complex. Even strategies described as passive can involve significant active management elements.
For example, an automated investing platform may utilize both active and passive techniques. Although it primarily adopts a passive approach, daily trading activities and annual portfolio adjustments indicate that it is not entirely inactive. This raises an important question: what truly sets these two investment strategies apart?
Defining active and passive investing
Both active and passive investing involve decisions about where to allocate funds. Retail investors, professionals, or entire investment firms make choices based on various factors. However, the key differences lie in their goals and the related costs.
Active investing explained
Active investing seeks to outperform market benchmarks through strategic decision-making and timing. This method typically requires extensive research, analysis, and frequent trading, which can result in higher fees. For instance, the S&P 500 serves as a common benchmark for U.S. large-cap stocks, with less than 15% of actively managed funds managing to outperform this index over extended periods of five years or more.
This does not diminish the significance of active investing, especially in less efficient markets. In areas such as developing economies or specialized bond sectors, the potential for identifying undervalued assets may increase. Therefore, the expertise of the management team becomes crucial when investing in actively managed funds, as their track records can greatly impact performance.
The role of management teams
Choosing an actively managed fund means placing trust in the team behind it. Conducting thorough due diligence on their experience and historical performance is essential. In our investment portfolios, we employ rigorous quantitative and qualitative assessments to evaluate the teams managing these funds.
Additionally, some niche markets may lack passive investment options entirely. A relevant example is the Academy Veteran Bond ETF (VETZ), which focuses on loans to U.S. service members and veterans. This fund represents a successful combination of active management principles and responsible investing.
The case for passive investing
Conversely, passive investing generally centers on tracking a specific market index rather than attempting to outperform it. Index funds, such as those based on the S&P 500, automatically adjust their holdings based on the market capitalizations of the companies within the index. This self-adjusting mechanism ensures that underperforming stocks gradually decrease in weight, while high-performing stocks gain a larger share over time.
The rise of smart beta strategies has further blurred the lines between active and passive investing. Smart beta funds start with a traditional index and actively adjust their holdings based on various quantitative factors. For example, the Goldman Sachs Smart Beta portfolio focuses on companies that exhibit specific performance attributes, providing an innovative approach to index investing.
Blending both strategies
Investing is rarely a strict choice between two opposing strategies. At Betterment, we acknowledge the value each approach contributes to a comprehensive investment strategy. Our offerings often blend both active and passive elements, enabling investors to capitalize on the strengths of each method.
For example, an automated investing platform may utilize both active and passive techniques. Although it primarily adopts a passive approach, daily trading activities and annual portfolio adjustments indicate that it is not entirely inactive. This raises an important question: what truly sets these two investment strategies apart?0
For example, an automated investing platform may utilize both active and passive techniques. Although it primarily adopts a passive approach, daily trading activities and annual portfolio adjustments indicate that it is not entirely inactive. This raises an important question: what truly sets these two investment strategies apart?1