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Active v Passive Investment Management – what is it?

There are essentially two main investment management techniques, Active and Passive.

Actively managed funds are those where the fund manager aims to outperform the market by frequently buying and selling securities that they think are going to do better than others[1]. Passive investment funds, also known as index funds, simply buy a portfolio of assets that ‘mimic’ an index, like the ASX 200[2].

Explaining the difference

Actively managed funds are suitable for investors that want to concentrate on certain sections of the market or want more control over the assets they invest in. These funds typically suit the ‘aggressive’ investor who is willing to pay more for a fund that has the potential for high returns.

A fund manager’s expertise, experience, skill and judgement is being utilised when investing in an actively managed fund. Typically, these funds are more expensive as you are paying for the investment skills of the fund manager and there is a lot more work and transacting in the pursuit of investment returns.

For example, a fund manager may have extensive experience in the automotive industry; so as a result, the fund may be able to beat benchmark returns by investing in a select group of car-related stocks that the manager believes are undervalued.

Active fund managers have flexibility. There is typically freedom in the stock selection process as performance is not tracked to an index. Actively managed funds allow for benefits in tax management. The ability to buy and sell when deemed necessary makes it possible to offset losing investments with wining investments.[3]

Passive funds are generally cheaper, as you are not buying a fund managers’ ‘expertise’. Passive or Index funds are generally a buy and hold strategy, with the aim of generating steady returns over a long period of time.

For example, an index fund may replicate the ASX 200, but still hold different stocks to that of the ASX 200. This ensures that the risk and returns are similar, but not exactly the same as the ASX 200.

When a passive management strategy is employed, there is no need to expend time or resources on detailed research and stock selection or market timing, which means there are lower management fees. Because of the short-term randomness of returns, investors would be better served through a passive, structured portfolio based on asset class diversification to manage uncertainty and position the portfolios for long-term growth in the capital markets[4].

The conclusion?

There is ongoing debate about whether active or passive fund management is better and there are a lot of pros and cons for both methods. However, it is truly all about how an investor feels, what they believe in what are the drivers of returns, and which investment strategy suits better.

At Lumen we believe that a diversified portfolio across different asset classes blending various investment styles and strategies produces the greatest potential to maximise long term investment returns.  Like many things in life, with investing, there is no one solution fits all.  It really is about you the investor and what your goals are and what you feel comfortable with in making important investment decisions.

[1] https://www.moneysmart.gov.au/investing/managed-funds

[2] https://www.moneysmart.gov.au/investing/managed-funds

[3] http://www.investopedia.com/terms/a/activemanagement.asp

[4] http://www.investopedia.com/terms/p/passivemanagement.asp