Active vs. passive investing: Determining the right mix at the right time
Morgan Stanley Investment Management10/25/21
Summary: We break down the differences between active and passive investing and show how both, separately or together, may add value to portfolios.
It’s a common question among investors: Active vs. passive investing—which is a better fit for my financial goals? The fact is, there are benefits to each and both strategies may be valuable. When evaluating which approach to use in one’s portfolio, the first step is to understand the differences between the two, including their objectives and the situations in which they tend to perform well.
Active aims to outperform
Active investing involves paid human portfolio managers whose goal is to “beat the market” over time with their self-selected securities. This is typically done through a mutual fund. Because active investing generally involves teams of investment managers buying and selling investments to seek maximizing growth, their fees can be higher.
Passive strives to match the market
Passive investing, on the other hand, involves investing with the objective of matching the performance of a certain market benchmark (before accounting for fees and expenses), not necessarily outperforming it. This is typically done through an exchange-traded fund (ETF), for example, an ETF that tracks the S&P 500® index. Passive investments are not actively managed by human portfolio managers, so any fees investors pay are generally lower.
While active management can theoretically help investors beat the market’s performance, the higher fees can cut into potential profits. It’s partly because of this difference in costs that passive investing has often outperformed active in certain markets—once management fees are subtracted from investment gains, active strategies may not outperform in terms of real return to investors.
When (or where) do they shine?
There’s more to the story, though. When it comes to deciding between the strategies, context can be important. Market conditions can factor into differences in active and passive performance. Active investments have tended to outperform in a volatile market or declining economy.1 Passive investments may achieve better results when equities follow a uniform path alongside the broad market.
Also, different regions or sectors may be better suited toward active or passive management. For example, active investing has historically been profitable in emerging markets, while passive investing has tended to be successful in US markets.2
In any situation, when evaluating an actively managed fund, it’s important to assess not only returns, but also the organization, portfolio managers, transparency, and communications. Use resources such as a fund’s prospectus, website, commentary, and performance report as a sounding board.
This is not an ‘either/or’ situation. We see an important role for both active management and passive options.
A blended approach
Perhaps the best part of active and passive investing is that investors don’t have to choose one or the other—they can use both. Generally speaking, investors may benefit from a blended approach that mixes the characteristics of the two strategies, emphasizing their upsides while mitigating their downsides.
By combining approaches, investors can potentially benefit from a more balanced and diversified portfolio. As always, though, any decisions should align with individual goals, timeline, and risk tolerance.
|Active investing||Passive investing|
|Goal||Beat the market||Match the market|
|Strategy||Managers select securities||Track an index|
|Pros||May outperform benchmarks||Lower fees|
|Cons||Higher fees can eat into returns||Limited to market returns|
- The Morgan Stanley Minute, The Case for Active Investment, accessed 10/6/21
- Morgan Stanley Investment Management, “Active vs Passive: Determining the Right Mix at the Right Time,” September 2021
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