Article written by: Carolyn M. Denest, CFP®, CPA/PFS
The debate over active vs. passive investment strategies is not new but has become more prevalent in recent years among financial advisors and individual investors. Thanks to a record number of funds available, lower costs and a strong bull market now in its 12th consecutive year, we have seen a significant rise in the popularity of passive strategies. Of the $19.5 trillion currently invested in mutual funds and ETFs, passive strategies now represent 40% of the market1. As further evidence, net cash inflows to passively-managed funds have exceeded that of their actively-managed counterparts in each of the past five years1. To appreciate this growing trend, it is important to understand each approach to portfolio management and the differences between them.
Under an active approach, portfolio managers select investments based on their independent research and evaluation of specific securities, sectors and regions as well as the current market environment and outlook. They look for investments which they believe to be attractive opportunities. Active managers have the flexibility to increase or reduce portfolio allocations at their discretion provided they stay within the fund’s investment mandates. Their performance goal is to “beat the market”. By contrast, the goal of a passive approach is to simply match performance of a specified market index rather than outperform the benchmark. To do so, managers generally invest in the same holdings and at the same pro-rata allocations as the corresponding benchmark index. As a result of this difference in management style, higher costs are associated with active management (i.e. research analysts and transaction costs due to more frequent trading.)
From a historical perspective, comparative performance has fluctuated between the two portfolio management styles. Based on average historical returns, each approach has shown a tendency to perform better in different market environments. In general, active managers tend to outperform in down markets and periods of market volatility, while passive managers tend to outperform in up markets. History has also shown notable consistencies in outperformance within different asset classes or areas of the market. Actively-managed strategies often outperform where information is less available, liquidity is limited, and trading is more difficult. By contrast, passively-managed strategies tend to perform better in efficient markets with deeper liquidity.
At Domani Wealth, our investment philosophy recognizes the merits of both active and passive investment management. In most cases, we believe in a hybrid approach as both actively-managed and passively-managed strategies can serve an important role in a well-diversified portfolio. We continue to encourage a risk-appropriate asset allocation with a long-term perspective as the best course of action to reach financial goals. Should you have questions on your investment portfolio or wish to meet with one of our Wealth Advisors, please contact our office.
1 Source: Morningstar. Data as of July 31, 2019.
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