Passive vs. Active Portfolio Management: Which is Right for You?

Originally published in L.A. Business First

2022 was a troublesome year for investors. Of the major market sectors in the S&P 500, only Energy performed positively. Bonds, international securities, and currencies separate from the U.S. Dollar all declined. Investment portfolios across the globe took major hits. If you had your investments with a passive portfolio manager, chances are you missed crucial windows to exit certain declining markets and enter others.

Among investor portfolios, two styles dominate: passive portfolio management and active portfolio management. Both have their advantages and disadvantages, but which you choose will depend on a number of factors.

What is passive portfolio management?

Passive portfolio management is an investment approach that seeks to track the performance of a particular market index or benchmark, rather than trying to outperform it. Passive portfolio managers, therefore, do not try to pick individual stocks or make active decisions about asset allocation. Instead, they aim to build a portfolio that is broadly diversified and reflects the overall composition of the market or benchmark that they are trying to track. Due to its scalability and low cost, passive portfolio management has become increasingly popular with major securities firms and investors with limited funds and/or risk tolerance.

What is active portfolio management?

Active portfolio management, by contrast, involves actively making decisions about which assets to buy and sell, as well as how to allocate assets within a portfolio, to outperform a particular benchmark or index. Active portfolio managers seek to generate returns that are higher than those of a particular market or benchmark by using various strategies, such as picking individual stocks, timing the market, or taking positions in undervalued assets.

Active portfolio management is typically more expensive than passive management due to the increased research and analysis that is required, as well as the higher transaction costs associated with frequent buying and selling. However, it has the potential to generate higher returns if the active manager is successful in outperforming the market.

What should be considered in a portfolio management style?

While passive portfolio management can mitigate declines in any one asset, there is often little room left for outperforming an index. Passive portfolios often hold numerous mutual funds with overlapping holdings, but because each fund contains hundreds or thousands of holdings in such small percentage allocations, there is very little variance to broad market indexes.

In contrast, active portfolio management involves a more hands-on approach to investing. Active portfolio managers may use a variety of techniques to try to identify opportunities for outperformance, such as fundamental analysis, technical analysis, or a combination of both.

When one is considering whether active or passive is the best style for them, below are some factors to consider.

Time horizon of the investment.
Tax consequences in the account of the investment.
Acceptable and measured volatility of the investment.
Level of attention that one wishes to give to the investment.
Level of contact and education provided by the advisor or investment firm holding the investment.

Portfolio management

The greatest disconnect between active and passive portfolio management can be seen in the long-term bond market. Long-term bonds have been allocated to portfolios to decrease volatility and add to return since the high in interest rates in the early 1980s. This blended approach seemed to work until interest rates bottomed in July of 2020. At this point, there was no advantage to purchasing longer-term bonds when measuring possible price volatility risk versus possible performance expectations.

This being the case, why did passive portfolios across the board not adjust their allocation to fixed income at this low point? Even if this low point was missed, the Federal Reserve said it intended to decrease money supply and increase interest rates to thwart inflation. By any stretch of the imagination, the expected outcome for investments in fixed income would be expected to be destructive to overall portfolio performance.

As you can see, there are many other points to consider when selecting a financial professional. While 2022 was dreadful year for investing in general, would more actively managed portfolios have helped individual investors? Or would passive management have kept activity and tax consequences to a minimum? Each situation must be examined individually.

Tower 68 Financial Advisors can help you understand which portfolio management style is right for you. To learn more, give us a call at (949) 945-6970 or via email at info@tower68.com.

Important Disclosures:

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific situation with a qualified tax advisor.

Asset allocation does not ensure a profit or protect against loss.

No strategy assures success or protects against loss.

Stock investing includes risks, including fluctuating prices and loss of principal.

Bonds are subject to credit, market, and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.