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Kenneth Grimes:

When people talk about active investing and passive investing, they always seem to place them in opposition to each other—active versus passive. Does it have to be that way?

In this video, we'll explore both active and passive approaches, their similarities, differences, and how they might work together in an investment portfolio.

Let's start with a definition of a market index since indexes play an important role in both active and passive investing.

An index is a basket of securities or other financial instruments that represent the performance of an asset class, sector, or investment strategy.

As an example, the S&P 500 is one of the most widely used stock indexes. It's comprised of the 500 largest publicly traded US-based companies.

With active investing, the goal is to create a portfolio that will outperform an index. Human beings use company data and analytical tools to select specific securities.

This often involves teams of investment professionals analyzing financial data and information specific to each security. Some active managers also employ macroeconomic forecasts and quantitative algorithms along with regional or sector views.

With passive investing, the investment objective is to match rather than beat the performance of an index.

To accomplish this, a portfolio will typically hold the same securities in the same proportion as its index. Some strategies achieve this with a smaller but representative sample of the index securities.

After initial setup, adjusting the strategy to match changes in the index is automated.

Let's take a closer look at some of the characteristics of the two approaches.

Flexibility—active managers can buy and sell stocks, even exiting or entering entire sectors or increasing cash in their efforts to beat an index and limit losses during a downturn.

A passive strategy rises and falls in lockstep with its benchmark. It is not set up for major modifications or event-driven adjustments.

Transparency—some investors want to know real-time details of the investments owned by a strategy.

Active strategies provide detailed holdings less frequently or with a lag since most investment managers use proprietary research and approaches.

Passive strategies are often more transparent, with some reporting holdings daily.

Risk—active strategies may entail greater risk in exchange for the possibility of greater rewards. How much more risk depends on how different a portfolio looks compared to its benchmark.

Passive strategies are not risk free and can lose value, but the losses result from market exposure.

Fees—because bottom-up company research is conducted by teams, including portfolio managers, research analysts, and others, active strategies can charge higher fees than their passive counterparts.

Because passive strategies are adjusted automatically with much less human engagement, expenses tend to be lower.

And lastly, tax efficiency—passive investments may have lower turnover than active investments, and lower turnover may produce fewer capital gains and associated taxes.

On the other hand, active managers have the flexibility to rebalance and customize strategies to be more tax efficient.

What else?

Because passive investments can be both easily and quickly executed, they may be used temporarily within active strategies to maintain exposure to specific economic sectors or geographies as portfolio managers research opportunities for excess cash.

Passive investments can be useful, too, for rapid portfolio adjustments before or after major events such as a national election, for example.

Regardless of the approach—active, passive, or combination—remember that active versus passive is just one of many important decisions that need to be made when constructing an investment portfolio.

Always be sure to take into consideration your overall investment goals, time horizon, risk tolerance, liquidity needs, tax circumstances, and other factors.

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