Active vs. Passive Investing 101

This means picking investments based on a big-picture economic overview. For example, if you think oil prices are likely to rise, you might favor investments in the oil industry and related sectors. You might also shy away from sectors that are heavily dependent on petroleum-based products and thus might be harmed by rising oil prices. 

This means picking stocks and other securities one by one, based on their individual characteristics.

Bottom-up investing involves intensive analysis of specific companies. You would look at a company’s business model and competitive positioning. You’d consider the supply and demand characteristics of its industries, and look at other economic factors that could affect the business.

Once you had a firm grip on the company’s prospects, you’d do some detailed modeling of its earnings outlook and compare how the value of its earnings stream would compare with the current price of the stock.

Of course, US stocks aren’t the only asset class. Besides expanding the pool of stocks to include those based in foreign countries, you also have the opportunity of investing in corporate bonds, federal government bonds, and municipal bonds. 

You might also consider more specialized asset classes, such as commodities and real estate.

Each of these asset classes is affected by different things and will react positively or negatively to changing economic and market conditions. You can vary your asset mix to favor those classes of securities you believe are best positioned for emerging trends.

Even staying within stocks, there are different sectors and styles from which to choose. You can actively manage the combination of these subclasses in your portfolio and rotate from one sector or style to another as you believe conditions dictate. 

For example, if you feel a recession is coming, you might want to avoid sectors such as travel and luxury businesses. In an overpriced stock market, you might lean toward value rather than growth stocks. 

Being able to adjust your portfolio characteristics according to company sectors or investment style creates many opportunities for active management.

People who seek a portfolio representative of the US stock market generally choose an index fund based on the S&P 500. Based on data from the Investment Company Institute^[1], this single index accounts for 29% of all the money invested in US index funds.

Stocks in the S&P 500 represent over $30 trillion in market value, according to data from S&P Global^[2]. So, it’s certainly a broad way to define the stock market. However, it isn’t the only way.

The S&P 500 is dominated by very large companies. To get even broader market representation, you might consider an all-cap index, which includes smaller and mid-sized companies. 

Of course, the US is not the only market^[3], so to take an even broader approach you might choose a global index which includes both US and foreign stocks.

Instead of taking a wide-angle view of passive investing, you might choose to target more specific market segments to comprise your portfolio. 

This may involve concentrating your holdings in stocks of specific countries or regions. It might also involve targeting stocks in a specific size category, with small-cap, mid-cap or large-cap funds. 

While passive investing is largely a hands-off process once you get your portfolio set up, there are still decisions to make in terms of how you structure that portfolio.

If the mission is to take a different approach from broad market participation, it’s especially important to identify the goals of that approach.

For example, while many people have it in mind to beat the market when they pursue active investing, there is more than one way to define outperformance.

Earning a higher return than a benchmark is one way to outperform, but you may also use active investing as a way to hedge or reduce risk. In that case, the idea may be to do better than the market in down markets. 

Whether you are trying to earn a higher return than the market or manage risk, you should look at returns on a risk-adjusted basis. This takes into account both the return you earn and the amount of risk you took to get it. 

Also, while active portfolios are designed to differ from the market, it is important to define just how different you’re comfortable being. The more your portfolio differs from the market, the more able you are to take advantage of opportunities and pricing inefficiencies in the market. At the same time, depending on your situation it may not be prudent to completely ignore basic principles of diversification. 

Be prepared that active portfolios tend to trade more than passive ones, and thus may incur taxable gains more frequently. 

However, this disadvantage is negated when you use an active approach within a tax-advantaged portfolio like a retirement account.

Because active portfolios trade more often and require more intensive decision-making than passive portfolios, they are generally more expensive when it comes to trading costs and management fees.

When evaluating an active approach, it’s important to evaluate whether the past results and future potential are worth the added costs. 

When you choose to mimic a certain index, make sure the fund or other vehicle you use stays as close to that index as possible.

When evaluating an index fund, look for a statistic called tracking error. This measures the extent to which past performance has deviated from the performance of the target index. Also consider the fund’s methodology for keeping its holdings in line with those of the target index.

The constituents of indexes don’t change that often, so passive portfolios tend to have low turnover. This means less frequent taxable events.

However, income from indexed holdings is taxed, so income-based approaches might see a higher portion of their returns taxed. Finally, a fund that experiences heavy outflows of money may be forced to liquidate investments, triggering tax consequences even for people staying in the fund.

The low turnover and less intensive decision making of passive funds means they generally cost less than active approaches.