Active Asset Management vs. Passive Asset Management
Active and passive assets may seem easy to distinguish by definition, but in practice, it becomes much more complicated.
Active Asset Management
The active investing strategy involves frequent trading to gain more significant index returns than usual. To handle this type of investing, you need a high level of expertise and market analysis to determine the best time to buy or sell your investments.
A business owner can do active investing or assign someone else within the company to do it. Alternatively, you could use actively managed mutual funds and active exchange-traded funds (ETFs) to outsource your active investing to professionals. Through this route, you can expect to receive a ready-made portfolio of hundreds of investments.
Active fund managers will assess a wide array of data in these portfolios. This may include qualitative and quantitative data about securities and broader market and economic trends. Using that information, active managers will capitalise on short-term price fluctuations by buying and selling assets to keep the fund’s asset allocation on track.
Advantages of Active Investing
- Tax management: Savvy portfolio managers and financial advisors can use active investing to make trades that offset gains for tax purposes. This is known as tax-loss harvesting.
- Flexibility in volatile markets: To avoid catastrophic losses during down markets, an active investor can move to a defensive position or hold by using cash or government bonds. Investors can also reallocate so that they may hold more equities in a growing market.
- Expanded trading options: Active investors may use trading strategies such as shorting stock or hedging options. This will produce windfalls that increase the odds of them beating market indices.
Disadvantages of Active Investing
- Increased risk: If even one high-yielding investment goes wrong, it can drag down your portfolio performance and result in catastrophic losses. This is especially risky if you borrowed money or margin to place the investment.
- Higher fees: Actively managed funds require a large amount of research and trades. This can result in a high expense ratio for example 0.71% in 2020.
- Trend exposure: The difficulty of trend-based investing is that you never know whether a trend is at its peak or still has room to grow. Making the wrong choice could result in a significant loss.
Passive Asset Management
The passive investing strategy focuses on buying and holding assets in the long term. This is often used for a longer-range goal, like retirement. The business owner will choose the security and hold on through the ups and downs. For this reason, it is described as a hands-off approach.
A passive strategy requires passive managers to purchase shares of index fees or ETFs that aim to mimic the performance of major market indices. Examples may include S&P 500 and Nasdaq Composite. You can either buy shares of these funds in a brokerage account or get a robo-adviser to do this for you.
Passive investment is popular among financial advisors because it doesn’t require daily attention. This set-it-and-forget-it approach leads to fewer transactions and much lower fees.
Advantages of Passive Investing
- Decreased risks: Since passive strategies are more fund-based, you’re investing in hundreds, if not thousands, of bonds and stocks. This means that one bad stock won’t significantly damage your portfolio.
- Higher average returns: Long-term passive funds almost always result in higher returns. According to an S&P Stock Exchange Indices report, 90% of index funds tracking companies outperformed their active counterparts over three years.
- Lower costs: Passively managed funds charge lower expense ratios due to little research and upkeep. In 2020, the expense ratio for passive ETFs was 0.18%, while mutual funds were 0.08%.
- Increased transparency: The index your fund tracks will be part of your fund's name. Passive investing doesn’t hold investments outside of its namesake index.
Disadvantages of Passive Investing
- It’s not flashy: A single stock won’t give you a quick and significant return. Returns only offer great results after years of accumulating funds.
- There’s no exit strategy in a severe bear market: Because it’s a long-term plan, you can’t simply withdraw when experiencing a severe market downturn. However, regular assessment of asset allocation may prevent this.
