Passively managed investments that seek to mirror a market index and their actively managed counterparts each have their own merits. Investors should use active or passive funds where each has the best chance for success.
Certain market conditions can favor one over the other. Actively managed funds tend to perform better in down to flat markets, while passively managed funds can do better in up trending markets when it is hard to beat the benchmark.
Active funds also tend to do well in less efficient asset classes like small- and mid-cap stocks. For example, in the whitepaper “Active vs. Passive Money Management” from Baird’s asset manager research team, we found the median small-cap value fund outperformed its benchmark 67 percent of the time, while the large-cap core fund outperformed only 20 percent of the time.
There is a significant difference between average and above average active managers, but it takes due diligence and time to identify top managers. The success and excess return potential of top quartile versus bottom quartile funds makes an investment in due diligence worthwhile.
Passive investments can round out a portfolio’s asset allocation. For more efficient markets like large-cap core, passive S&P 500 index funds make sense, especially for those who want to get close to the market return. These funds also generally have lower fees. However, passive approaches do not work as well for certain asset classes like fixed income, where it is often more difficult to replicate a benchmark.
To determine which is best for your situation, there are several considerations:
- Time horizon – For shorter timeframes, passive may fit your situation; if three to five years or longer, active may be more appropriate.
- Fees – Passive elections typically have lower fees. An advisor who knows your personal situation can help determine whether paying higher fees for an active manager is right for you.
- Taxes – Passive funds often have lower turnover, generating fewer capital gains. Keep in mind that good managers can capture excess returns by trading securities.
-Kathy Blake Carey, CFA, is director of asset manager research for Robert W. Baird & Co.’s Private Wealth Management business.
