Active vs Passive: The Great Investment Debate
What are active and passive investing?
The question of active or passive investing – which to use, which is better? – may have begun decades ago but remains a hotly debated topic today. What is active investing? It is an investment method that relies on skilled managers to research and select investments that are expected to generate higher returns than the broader market. By contrast, passive investing seeks simply to replicate a market index, often at low cost, gaining returns comparable to that of the broader market.
How Does Active Investing Work?
In active investing, a portfolio manager or individual investor makes specific buying and selling decisions based on the analysis of various factors, including market conditions, economic trends, company financials and other relevant information. Typically, this approach requires a high level of involvement, decision-making, and ongoing monitoring compared to passive investing. Managers can choose to be active – to make choices that differ from an index – in two different ways:
- Security selection: Active managers use their research and analysis to identify undervalued or overvalued securities. They often pick stocks and bonds using one of two different techniques. The first is fundamental research. Managers look at financial health (analysis of financial statements and interviews with company management) and industry trends of individual companies. The second is quantitative investing. Managers use data such as price history and financial ratios in a systematic process or a model to make investment decisions.
- Asset allocation: Active managers may also, or alternatively, choose to overweight or underweight certain sectors or asset classes in their portfolios in an effort to generate greater returns than an index.
Active management may help an investor meet specific investment needs that are different than needs that may be met by investing in an index. Examples include a niche focus (such as sustainability) or reducing risk (or volatility). But the heart of active management is the promise of higher returns – and that promise depends on sustained investment skill, carries higher costs, and involves a higher level of risk and uncertainty.
Which Is Better: Active or Passive Investing?
Although active and passive investing are often pitted against each other, investors should consider the benefits of both. State Street Global Advisors, the investment manager for ECF’s Endowment Management program, finds that both active and passive investing may have a place in a portfolio, depending on an investor’s goals.
In large and efficient asset classes, State Street believes that passive investing can be a good way to build a core portfolio – it is less risky and less expensive than active management. But in other asset classes, State Street believes that active management can add value. It uses active management in asset classes in which the flow of information is less efficient and the median manager has a history of outperforming benchmarks. A portfolio that combines active and passive management gets the best of both worlds: the lower cost and lower risk of index investing, plus exposure to active management where it has a track record of adding value.
Are you seeking the right balance in your endowment investment strategy? Contact ECF’s Endowment Management experts at [email protected] or call 800-697-2858 to discuss your investment goals.