Passive vs. Active Portfolio Management | (2024)

InstructorIan LordShow bio

Ian is a 3D printing and digital design entrepreneur with over five years of professional experience. After six years of aircrew service in the Air Force, he earned his MBA from the University of Phoenix following a BS from the University of Maryland. He is also a real estate investor, board gamer and homebrewer.

In this lesson, you'll learn how mutual fund portfolios can use either a passive or active portfolio management strategy. We will also address the differences in factors, such as cost and risk, in these approaches.

Table of Contents

  • Portfolio Management Strategies
  • Passive Management
  • Active Management
  • Lesson Summary

Tom is preparing to invest in mutual funds. He has seen references to a fund being either passively or actively managed, but he's not quite sure what that means. Let's explore the difference between these two management strategies and see how they can influence investment returns.

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Passive portfolio management is a strategy used by index funds. In these types of funds, the mutual fund company buys and sells stocks to match or approximate a market index or benchmark. For example, one mutual fund portfolio might attempt to mirror the S&P 500 stock market index. Stocks are bought and sold according to what companies are listed in the index. Indexes can be created for just about any class of investment, such as bonds, international investments, real estate, precious metals, or focus on specific industries.

The major advantage of this management style is that the decision of what to buy and sell is primarily driven by a computer software program that ensures the fund matches the index. The mutual fund manager oversees this system to ensure it is working as it's supposed to, but doesn't make decisions about buying or selling based on speculation about the performance of each investment. This results in reduced operational costs compared to active management. The savings get passed to investors like Tom because the fund provides the exact same return as the index minus whatever expenses the fund has.

The main argument against passive management is that the fund is only going to provide the return of whatever index is being used. If the S&P 500 index has gains of 12% this year, some individual stocks will make significantly more than that. Other stocks will lose money even if the market as a whole has increased in value. The drawbacks of passive investment are countered by the active management approach.

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An active portfolio management strategy takes the opposite approach to passive management. A portfolio manager or team of managers attempts to beat a particular index by trying to find opportunities to add value. Instead of buying the entire market, the fund seeks to find investments at a bargain price and sell at a significant profit. The funds don't have to exactly match an index, but the index acts as a basis for comparison in the fund's return.

It is a risky proposition for an individual investor to pick and choose which stocks to buy. However, an actively managed mutual fund has a full-time professional team with greater access to capital and access to massive amounts of market research. These aspects add significant costs to operating the fund, but the argument can be made that an effective management team creates enough extra value for the consumer to more than cover any additional expenses.

There are a number of risks with active management. If a fund has made above-market returns and the fund manager leaves the company, there is a distinct possibility that the successor will be unable to repeat that performance. A manager might get lucky one year and make a significantly above-market return, only to experience severe under-performance the following year.

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Index funds use a passive portfolio management strategy to automate investment purchases and sales according to a specific market index, such as the S&P 500. Because the system is reliant on computer automation, the fund has incredibly low operating costs, which allow the investors to receive an average market return minus the minimal fund expenses. Active portfolio management attempts to get higher returns than an index fund by using professional managers to pick and choose which investments are in the fund. These funds have higher expenses, but offer the opportunity of higher returns in exchange for the additional risk.

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