Asset Class in Focus: Active vs. Passive Management

July 2021

Over the past decade, the debate over active vs. passive management has emerged as one of the most talked-about topics in the investment community. Investors aren’t just talking about it; many are showing their views by how they invest their money. Assets have poured into passive strategies over the last decade, with passive funds tallying inflows of nearly $4 trillion between 2010 and 2020. This compares to outflows of $185 billion from active funds over this period.[1] If the trend continues, passive funds may soon overtake active funds in total global market share.

To help you make sense of the debate, BDO Wealth Advisors’ investment representatives provide their perspectives on active vs. passive investing and the roles each strategy can play in an investor’s portfolio.
 

Defining Active vs. Passive Management

Put simply, active managers try to beat the market, and passive managers try to match the market. In a passive strategy, a portfolio manager seeks to track the performance of a given index as closely as possible. For example, a passive U.S. large-cap equity strategy may seek to match the performance of the S&P 500 Index. On the other hand, active managers seek to generate investment alpha, or outperformance relative to a stated benchmark. For example, an active U.S. large-cap equity strategy may seek to outperform the S&P 500 Index.

Because passive and active managers have different goals, the way they manage money differs significantly. Passive strategies generally don’t require frequent buying and selling of securities, so turnover tends to be relatively low. On the other hand, turnover can be quite high in active strategies, as an active portfolio manager will often sell securities and buy others as they come in and out of favor. But low turnover doesn’t necessarily mean that a strategy is passive; there are many active managers who hold a basket of positions for an extended period of time with limited turnover.

Because of the more hands-on, research-intensive nature of active investing, active strategies generally come with higher fees relative to passive strategies. Investors are charged a premium for the services of an active manager, stemming from higher research and trading costs, as well as the potential for outperformance. For passive managers, the main goal is to track an index as closely as possible while limiting fees and expenses.
 

Evaluating Active and Passive Managers

Because passive managers are trying to match the market, investors will want to carefully consider a passive manager’s tracking error — or the extent to which their performance differs from their stated benchmark — when evaluating a passive fund. Passive funds typically underperform their benchmarks slightly after accounting for fees and expenses, so limiting fees is a key area of focus for passive investing.  

When evaluating an active manager, investors seek to identify a manager today who will outperform the market in the future, which is a challenging exercise. Investors often judge active managers based on their past performance, but that is no guarantee of future results. In addition to a manager’s track record, investors should seek to understand an active manager’s investment philosophy and process and ensure alignment with their goals. We would also caution investors in active funds to avoid managers that act as “shadow indexers,” meaning that they hold a large number of securities and adopt a more passive approach despite charging higher fees. The ideal number of holdings will vary by asset class and strategy, but we would be wary of active funds with a large number of portfolio positions.
 

Commonly Overlooked Features of Active and Passive Strategies

Many investors may not understand some of the tax implications of pooled fund vehicles, such as mutual funds. For example, when mutual fund managers sell positions to adjust portfolio exposure or fund investor withdrawals, these sales can trigger realized gains, which create tax obligations for all investors in the fund in a given tax year regardless of when they initiated their position. Note that this issue can arise with both active and passive mutual funds, but passive mutual funds are generally more tax-efficient than active funds because they tend to have much lower turnover. Buying an index through an exchange-traded fund (ETF), on the other hand, can be much more tax-efficient.

In passive management, investors also tend to overlook that tracking a typical market-cap-weighted index introduces a potentially fundamental flaw: market-cap-weighted indexes are inherently titled toward securities that have performed well lately and underweighted to those that have underperformed. This tends to contradict one of the most basic tenets of investing: buy low, and sell high.
 

Determining the Best Fit for You

The decision to use an active or passive strategy should be based on each individual’s unique circumstances, including their risk tolerance, existing market exposure, and tax situation. We also encourage investors to realize that active vs. passive isn’t necessarily a binary choice. Both approaches may have valuable roles to play in a portfolio. For most of our clients, we use a mix of both active and passive strategies, with the split varying depending on their unique situation.

At BDO, we also seek to bring an active lens to passive investing by using strategies based on equal-weighted index funds, rather than ones that are weighted based on market capitalization. Equal-weighted index strategies help to solve for the inherent momentum-based flaw described earlier — instead of giving the greatest weight to the companies that have appreciated the most, capital is evenly split across all companies in the portfolio. But even this decision to use equal-weighted index funds vs. market-cap weighted ones is, in a sense, an active decision that we are making.

No matter which side of the active vs. passive debate you may be on, your BDO advisor is available to discuss what mix of investment strategies can help you to achieve your goals.
 


 
[1] Source: Morningstar, “The Decade in Fund Flows: A Recap in 5 Charts,” January 2020.