Active vs. Passive Investment Management

If you follow along with the financial markets and keep in touch with your advisor, or watch CNBC from time to time then you have probably heard snippets on the topic of this Acorns article.  Active management versus passive management, which one is better?  

Active management is the process of either: managing your investments in a way to minimize declines when the financial markets pull backwards and maximize investment exposure whenever the market momentum is positive; or paying someone to manage them in this manor on your behalf. This process of consistently increasing or decreasing risk exposure based upon indicators of the market is starkly contrasted to passive management.  Passive management is the process of building your investment thesis with conviction, taking a position, and then waiting for your thesis to play out over years.

Sometimes the investment research process for these types of management differ, in addition to how frequently you conduct transactions.  Active managers are more likely to set exposure based on market technicals.  These technicals could be indicators like moving averages, relative strength, price inflection points known as support and resistance, and momentum indicators.  The investment thesis may not always be supported by a fundamental belief in a companies business model or profit potential and at times is more motivated by price discrepancies that can take place as the market digests new information constantly, while passive managers must focus on fundamentals. General market theory suggests that companies with sound business models who consistently grow profits will experience appreciation in their underlying stock prices over long periods of time. Passive managers pray that this theory holds true over the length of their time horizon. 

As we begin to compare and contrast the two, I’m sure you’re beginning to ask yourself the questions, “Which type of management is more effective?  Which type should I utilize?” If you’re familiar with this debate then you know there are passionate advocates for both passive and active management.  So passionate that at times we have seen talking heads join in shouting matches on live television. So, what do we believe here at Harvest Investment Strategies?  In short, we believe that both types are suitable for given investors dependent upon a myriad of factors.  In the remainder of this article we will dive into the pro’s and con’s of each in a list fashion, and follow up with a discussion of client types and or factors that may make one more appropriate than the other for yourself. 

Click to expand the following lists:

Passive Management

Benefits:

1. Simplified approach

   Passive management naturally cuts out decisions. It also cuts out time spent on watching the market, looking at technicals, and fundamental research.  Some believe that the fewer decisions you make, the less chances you give yourself to be wrong.

2. Low transaction fee

   By its nature passive management means less account activity which means lower transaction fees.  You can generally choose an extremely cheap investment option if your goal is to buy and hold for years to come.

3. Low or no management fee

   While this benefit isn’t always true, most of the time passive management advocates perform their own trades and pick their own investments. This means you do not have to pay someone else for their expertise of oversight. In addition, selecting indexed funds or mutual funds with the lowest possible fees is a priority for passive managers.

4. Potential for large asset growth

   Heard of someone turning a relatively small investment ($5,000) into a relatively sizable sum of wealth ($300,000)? These stories are usually associated with people who bought with the conviction to hold for years on end, not someone who utilized stop loss orders to salvage smaller gains over shorter periods. This takes patience to let the investment mature to full potential.

5. Reduce anxiety tied with the market

   Watching the market day in and day out can cause anxiety. Numbers jumping around, making vast sums or losing equal sums in the blink of an eye, geopolitical turmoil, or even international pandemics can make it hard to stomach volatile price fluctuations. Passive management allows you to simply not look. It is a set it and forget it approach.

6. Delay tax burden on unrealized gains (taxable accounts)

   Passive management inside of taxable accounts delays the burden of tax until you sell off a portion of all of your investment. While you will always owe tax on a profit, you can delay your burden for years on end as long as you don’t sell.

Disadvantages:

1. No investment advice (perform your own research)

   The number of investment options people have to choose from is astonishing. The S&P 500 alone is 500 companies to choose from, and with this many options it is tough to make a wise decision.  Having to perform investment research on your own during your spare time is a tough task, especially if you’re no expert on earnings multiples, technical analysis, or price volatility.

2. Potential for large asset declines

   While holding on to investments passively can lead to large gains, the flip side is also true. Take this brief real life example:  A $10,000 investment in Dell computer company invested in the year 1990, by 2000 was worth $7.19 Million.  Then by 2002 that 7.19 M was again worth only $650,000 and by 2013 was only worth $300,000. You may look at that and say turning 10k into 300k sounds great, but not if you realize you left 6.8 Million on the table. Large asset declines can easily take place for investors who never sell.

3. Create market and economic apathy

   Have you ever heard the old saying ‘don’t get sore, buy some more!’  Always buying more isn’t possible for normal investors who don’t have endless amounts of cash flow to continually add to their investments.  Passive investors generally become apathetic about the market movements believing that if they wait long enough things will return.  This feeling is paired with a desire to stop watching accounts and investments. If you’re purposefully not watching, apathy will set in.

4. Retirement year risk

   The last recession in the United States was in 2008. Can you imagine if you were 63-65 yrs old in 2008 and trying to retire?  Your 401k plan that was worth $2 million could have easily been worth $1.2 million in a few months. If you were planning to draw $80,000 per year at a 4% withdrawal rate, after 2008 you’d have been withdrawing 6.5%.  While its safe to retire on a 4% rate, 6.5% is unmanageable. You would’ve had to postpone your retirement several years, which is exactly what happened to many Americans.

5. Lack of liquidity

   If your intent is to never sell your investments, then your money is tied up.  A lack of liquidity can become a burdensome thing, especially if you have a personal liquidity crisis for an unforeseen event: medical issue, job loss, death of a family member, etc.  Sometimes the benefit of liquidity isn’t seen until the need for liquidity is already present and the problem is too drastic to address well.

6. Create false sense of confidence in poor investments

   If you have spent much time with investments you’ve probably heard people exclaim, ‘I’m down on it, but I’ll be patient…it will eventually come back they always do’.  This statement is false.  Companies go out of business all of the time and in the year 2020 we’ve seen more than 20 bankruptcies by well known companies like: JC Penny  and numerous others. Even if your investment doesn’t go bankrupt, you could experience large periods of drastic declines holding onto a business whose model doesn’t function anymore.

Active Management

Benefits:

1. Key investment advice from professionals

   This one may be obvious, but hiring an active manager means you receive advice from someone who spends their full working bandwidth studying investments for people

2. Fiduciary Interest

   Recently, actively managed style accounts are held to a fiduciary standard meaning the investment professional has to act in your best interest and not their own. They also have to disclose any potential conflicts of interest and would be subject to legal action if they’re found breaking the fiduciary standard.

3. Potential for outperformance

   In your college level finance or investing class you may have heard of Eugene Fama’s Efficient market hypothesis where he states that it is impossible to beat the market on a risk adjusted basis over a meaningful period of time because the market should be continually digesting new information.  But some active/hedge fund managers have consistently outperformed the market over meaningful periods of time.

4. Derivative Investments/Hedging Opportunities

   Generally active managers are well versed in all types of marketable investments meaning they have vast knowledge on options, leveraged etfs, volatility hedges, and indexed products. The knowledge these managers have allows them to utilize hedges against market declines as a % of account, as well as create defined outcomes of certain periods with stated risk.  These are advanced investment and trading tactics and should only be implemented by professionals.

5. Protects against retirement year risk/changing risk appetite

   Contrasting the downside to passive management, active management can help fight against retirement year correction/recession risk. Active managers are quick to apply the brakes on your investments as you near retirement.  Raising cash, or using stop loss provisions is an easy way to mitigate risk should a bear market present itself just before you’re hoping to retire and are in need of cash flow from your investment nest egg.

6. Provides Liquidity

   The constant entry and exit of investments for active management means that at times you’ll have cash uninvested. Uninvested cash can easily be transferred out for unforeseen expenses, or to take advantage of an alternative investment outside of marketable securities:  Real estate, business partnerships, home expenditures etc. The advantage here is natural liquidity where you can easily access your money without having to make a panicked decision of what investments to sell when the need for cash strikes.

7. Fosters market diligence

   If you hire an active manager and they continually fail to meet your expectations, chances are you will try another manager or at least change strategies. This pressure on managers to carefully and meticulously invest your money fosters the due diligence process. Due diligence is reading, studying, training, and creating continual investment thesis in order to adjust risk appropriately.

8. Tax Planning (taxable accounts)

   If you have an investment account that is a non-retirement registration, you will owe taxes on realized investment gains.  Tax loss harvesting is utilized frequently by active managers.  Perhaps you had a large gain through the sale of your business or real estate deal, active managers could help offset that gain by selling certain securities that you have unrealized losses stacked up in momentarily. The process can ease your tax bill, but be careful about the wash sale rule!

Disadvantages:

1. Management Fees

   Probably the most obvious downside of active management is that it will cost you some money. You’re hiring someone to work for you, and they deserve to be paid for their time and research so it makes sense that there is a fee but nevertheless this is an expense that exists in actively managed accounts.

2. Potential for underperformance

   Just as active managers have the potential to outperform the market, they have the potential to underperform the market indices as well.

3. Market Anxiety

   While passive management can create market apathy, active management can create anxiety.  If you’re following the market vigorously then you’ll battle the emotional swings of seeing your money fluctuate up and down.  Also the number of decisions that are being made can be anxiety provoking.

4. Caps large asset appreciation

   Having the $10,000 investment go to $2.19 million isn’t likely for active managers because generally a mid level trend will change before the investment runs that high. Reversion to the mean is a general rule of investing so it makes sense that large gains, who have run significantly higher over shorter periods should revert back to the mean. Active management will take profits quicker.

5. Forces you to choose a manager

   If you have a day job then you most likely don’t have the time to allocate to actively manage your own investment portfolio.  This means you’ll need to hire someone for the job. With so many active managers and each one employing a different strategy, this decision can be burdensome.

6. Want your cake and eat it too

   If you make the decision to hire an active manager you’ll likely battle with this analogy.  Clients that think active managers automatically outperform when the market is going upward and downward have unrealistic expectations. Managers are managing portfolio risk, not return.  Lofty expectations on your manager can create stress on them and force them to potentially make decisions that they otherwise would not have made. Most times a strategy is either defensive or aggressive. Defensive strategies grow very slowly but provide lots of short term protection, and aggressive strategies grow quickly but have short term onslaughts from time to time.

   
   

   
   

At Harvest Investment Strategies our value add is more apparent in our actively managed accounts; however, we believe that passive management has its time and place for certain investors. 

We begin our process with information gathering:  How old are you? How much savings do you have? What’s your investment goal? What’s your time horizon?  What’s your risk appetite?  The information gathering process tells us which strategy, active or passive, could be most appropriate for you.  Generally, young investors with higher incomes and long time horizons meet criteria for passive investments at least for pockets of their money. Liquidity needs generally force an investor into active management as passive management directly negates liquidity.  For active management the criteria are generally older in age, diminishing income, liquidity or income needs, and moderate risk appetites.  However, with pockets of this clients money it could be appropriate to engage in more passive investment strategy.  Having multiple pockets, or buckets, of investment strategies is often referred to a bucket strategy where the goal is grow your passive investment quick enough to replenish your active investment accounts through which you are taking supplemental income streams. 

We believe the shift from passive investments to active investments follows a natural timeline as investors age.  The greatest risk you’ll experience in your life is income risk.  This risk occurs in everyone's life as they age and no longer have the capacity to perform useful work.  Protecting the years of hard work you’ve completed is a key component of active management.  With this natural progression all of the answers to our information gathering questions shift for investors causing the type of strategy you employ to change. Without a sound strategy that aligns with your lifestyle or stage you are subjecting yourself to unnecessary risk.

If this Acorns article has cause you to ponder if your current investment allocations are sound, we’d enjoy the opportunity to analyze your situation. Our priority is making sure you have peace of mind and confidence in the process.  We would love to hear your thoughts on these points and hope you’ll reach out to us for further discussion. 

All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.