Improve Your Understanding of Passive and Active Investing

The pros and cons of indexing or not.

By + More

Lately I've been hearing a lot of consternation over passive versus active investing.

The recent financial crisis has caused a lot of advisors in the financial industry to trot out a lot of new ideas for their clients to "make sure that never happens again!" Thanks … really. But let's clarify what we really mean before anyone tries to answer the question, "Should I invest with a passive or active strategy?"

Passive investing—pros and cons. Passive investing is a strategy that attempts to reproduce or match the returns of an index. This strategy is not driven by a portfolio manager selecting individual securities, or by fundamental research. This provides a few benefits to the investor.

[See 5 Things You Should Do for Your Investments Now.]

With no portfolio manager or human capital overhead needed to track the performance of an index (computers do all the tracking), the expense of implementing a passive strategy is very low. Additionally, there are huge tax advantages because without a portfolio manager making decisions to buy and sell securities, there are fewer capital gains to pay tax on.

There is also some academic analysis that suggests that after fees, costs, and taxes are accounted for, it's very hard to beat an index—meaning any extra value a portfolio manager brings to the equation is offset by those costs.

There are some limitations. Specifically, if you own securities in that index, you will never beat that index. Simple enough—anything expressly designed to mimic an index will never outperform it. So any investor who thinks it is possible to beat the index will never settle for generating the index return.*

Additionally, if an investor employs a passive strategy and the market goes down, he or she will participate in that market decline one-for-one.

Active investing—pros and cons. This is generally defined as an investment strategy that employs a manager who attempts to generate returns in excess of the index the portfolio is benchmarked against. In other words, if a manager's benchmark index is the S&P 500, the manager is trying to generate returns that are higher than the S&P 500, after costs and taxes.

[See When Is the Right Time To Invest?]

Most managers attempt to do this by choosing stocks they think—based on their research and analysis—are inappropriately priced in the stock market relative to what their true value should be. For example, by discovering and purchasing the underpriced securities of the S&P 500 in combination with not buying the overpriced securities of the S&P 500, the manager should be able to outperform this index.

There are two big advantages of active management: the prospect of beating the index and protection in a down market. Managers and their staff are highly skilled and work diligently to identify information or insight into companies that everyone else may have missed. Discovering this information and executing a trade (to buy or sell a stock) is where active managers add value to the investor and perform above and beyond the index.

The other advantage, protection in down markets, is based on the same principle. An index, because it is not managed by a human, cannot take any precautions to protect the portfolio when the markets decline. Portfolio managers can actively raise cash by selling some securities if they feel the market is poised to pull back or they identify problems with the companies before the rest of the market discovers them.

One downside to active management is the fees associated with having the manager and his team. Salaries, rent, research, and travel costs are all paid for through fees paid by the fund's investors. If the fees charged to investors are 1 percent annually, the manager needs to outperform the index by at least 1.01 percent to be worth hiring.

There is also the potential that the manager may not be as good as he is lucky and won't be able to outperform the market consistently. There is research that suggests that most managers do not consistently outperform their benchmark year after year.

David B. Armstrong CFA, is a Managing Director and co-founder of Monument Wealth Management in Alexandria, Va., a full service financial planning and wealth management firm. Monument Wealth Management is backed by LPL Financial, the independent broker-dealer and Registered Investment Advisor. David has been named one of America's Top 100 Financial Advisors for two straight years by Registered Rep magazine (2009 & 2010) and has been interviewed by several national media sources for the past several years. David and Monument Wealth Management can be followed on their blog at "Off The Wall", their Twitter accounts @MonumentWealth, @DavidBArmstrong, and on their Facebook page. Member FINRA/SIPC.

* Indices referenced cannot be directed purchased or invested into, only the investments themselves. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results. Asset allocation does not ensure a profit or protect against a loss.