Active vs. Passive Investing: The Pros and Cons

The pros and pitfalls of active and passive approaches to investment

How close should an investor’s finger be to the pulse of their assets? As always in wealth management, the answer relies heavily on the individual’s circumstances and preferences alongside some tried and tested practices.

Some merely want to see the returns accrue without the stress of active management, while others enjoy being intricately involved with their portfolios. Both stances have benefits and drawbacks that must be considered before favoring a hands-off (passive) or hands-on (active) approach.

The good and bad of active management

Often described as trying to beat the market, hands-on investment management requires regular interaction with a portfolio in an attempt to capitalize on dynamics. Hot stocks or sectors and emerging trends are often drivers of investment decisions. And if the investor’s/portfolio manager’s belief in either is successful, it can lead to short-term returns far beyond those offered by a hands-off approach.

Higher risk is the biggest downside of active management. Even the most seasoned investors and their advisors can make poor and costly decisions. Data also don’t tend to back up an active approach that tries to spot specific companies or trends. Hands-on investing is typically a poor performer over a long horizon and even a mid-term one.

Hands-on investment isn’t just potentially more expensive if decisions fail. It’s also more costly in terms of management fees, given a portfolio manager’s increased involvement. Direct and indirect investors also pay far more trading fees.

Active investing still has devoted adherents, but it has become less popular, especially in light of the failure of various mutual fund managers to consistently beat market indexes. Most investors favor passive investing, a trend that Bloomberg termed “the end of an era” and an “epic shift.”

The pros and cons of hands-off investing

Passive investing does not imply “set it and forget it.” Hands-off investors are aware of their risk tolerance and investment horizon, and they do make changes to their portfolios to meet these goals in light of changing circumstances.

Passive investors simply understand these factors, make appropriate selections, and confidently let things develop with minimal involvement. This less-frequent portfolio interaction comes with a few perks. First, there’s the reduction in transaction costs and ongoing management fees compared to a hands-on model.

The next advantage is that passive investments typically provide a steadier return over the long term than active strategies. Hands-off investors leverage the market rather than effectively trying to beat it. And historically, the market always trends significantly upward over a long enough horizon. The caveat is that while passive investing is more predictable, returns may be less impressive than active choices in the short term.

Nevertheless, passive investing is backed by data and lower costs, and it has become widely popular. Exchange-traded funds (ETFs) that track market indexes are a primary vehicle for passively investing in stocks. They “now regularly account for a third of the trading on the US stock market and an even larger share in periods of high volatility.”

Passivity and greater tax efficiency

ETFs can defer the distribution of capital gains for extended periods, thus delaying the inevitable tax on those gains and allowing wealth to compound.

ETFs can have the further option of in-kind redemption—a process where securities are removed from a portfolio by an authorized participant in return for an equal value of shares. This circumvents capital gains taxes at the portfolio level, even if those securities are sold at a profit. However, should the investor later sell those shares at higher than the purchase price, capital gains tax is due.

Again, passive investing does not mean “set it and forget it.” All investors should understand the importance of active portfolio monitoring. Keeping a close eye on investments, fees, and market trends gives every investor more control and allows them to adapt their plan as their risk tolerance, goals, and time horizons change.

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