There are many strategies investors can utilize when building their portfolio. One common debate between investment strategies is whether to employ an active or passive investment strategy. In this blog, we will explain these strategies, ways to utilize these strategies, and key considerations when choosing a strategy.
What is Active Investing?
“Active Investing” is considered to a hands-on approach. Typically managed by a portfolio manager or another active participant, active investing seeks better returns than the performance of a set benchmark that may represent the wider stock market or a subset of the market by trying to capitalize on short-term price fluctuations. Frequent buying and selling typically occurs in active investing, and portfolio managers may need to have a high-level of market analysis and expertise to make informed decisions. While active investors can choose to select the investments, mutual funds and active Exchange-Traded Funds (ETF) provide ready-made portfolios with many investments.
When utilizing an active investing strategy, quantitative and qualitative data is often used to make informed decisions, and the data collected can range from specific securities to broader economic trends.
Advantages and Disadvantages of Active Investing
An active investing strategy could result in multiple advantages including:
- Flexibility in volatile markets – Asset reallocation can occur in real-time to respond to market conditions.
- Multiple trading options – Active investors can have the ability to hedge the active strategy with options or short stocks.
- Tax management – Portfolio managers can use active investing strategies to execute trades that can offset gains for tax purposes – such as tax loss harvesting.
Active investing also has disadvantages including:
- Higher fees – More sophisticated trading strategies could have higher associated brokerage fees than other investing strategies. For example, investing in actively managed funds can come with high expense ratio fees.
- Increased risks – Short-term investments from active investing have the potential to produce a gain, but also have the potential to lose. Active investing tends to follow the high-risk, high-reward trajectory and has the potential to cause catastrophic losses.
- Trend exposure – With active investing, it can be easy for investors to hop on trend bandwagons without fully vetting the risks of the opportunity. Active investors need to consider if the trend is in early-stages and has room to grow, or if the trend has already maxed out its potential.
What is Passive Investing?
Passive investing tends to follow the pattern of “set it and forget it”, where investments are held for a longer period of time than in an active investment strategy. A security is purchased and held through price fluctuations and changing market conditions. While active investing tends to focus on individual investments, one example of passive investing is purchasing shares of index funds created with the goal of tracking the average returns found in major market indexes.
Advantages and Disadvantages of Passive Investing
Like active investing, passive investing also has some key advantages including:
- Lower costs – passively managed funds tend to have lower associated expense ratios than actively managed funds.
- Decreased risk – passive strategies are typically fund focused, meaning the investment is spread out over hundreds to thousands of stocks and bonds. The volume could provide diversification to the portfolio and help to mitigate the risk.
- Increased transparency – indexes are transparent with the companies they include, which provides a level of transparency between the investor and brokerage. Actively managed funds may leave some of the specifics up to the discretion of the fund manager, and certain techniques may be kept confidential as trade secrets. This increased transparency of passively managed funds helps inform the investor.
Some of the unique disadvantages of passive investing include:
- No clear exit strategy – unlike active investing, where liquidating an asset may be timed with changing market conditions, there is not as clear an exit strategy with passive investing, leaving liquidation decisions in the hands of the investor.
- Lack of flexibility – since passive investing often tracks a set benchmark, the fund manager typically does not re-allocate capital in the face of severe market downturns. This lack of flexibility can be a deterrent for those who prefer that a money manager “correct course” on their behalf.
While active investing aims to capitalize on short-term gains in the market through a hands-on approach, passive investing aims to replicate the average returns with a hands-off approach. When choosing an investment strategy, it is important to consider the following questions:
- What is my risk tolerance?
- How volatile is the current market?
- What industries or growth stages do I want to invest in?
- Am I willing to hold onto investments for many years?
- Should I utilize a combination of multiple strategies?
For many investors, a combination of active and passive investing can help to diversify their portfolio, but it is important to consider the potential risks and benefits of each method. It may be wise to seek out an investment professional if you need help determining which strategy is right for you.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.