Active vs. Passive Investing: Understanding the Difference

Knowing how each type of investing works, as well as their advantages and disadvantages, can help retirement plan sponsors construct appropriate investment menus.

Before constructing a retirement plan investment menu, plan sponsors must ask themselves whether investments that use active management or those that are passive, or a mix of each, are best for their plans and participants.

Active Investing

While more plans have shifted to passive investing in recent years thanks to its long-term, lower-cost structure, experts argue there are advantages to including actively managed investment options in defined contribution (DC) plan investment lineups as well.

Josh Cohen, head of institutional defined contribution at PGIM, describes active management as a more hands-on approach, where an asset manager makes decisions about buying or selling a fund’s underlying holdings based on performance expectations. “[Asset managers] can use quantitative approaches to determine securities that have worse or better expected returns, and what’s called fundamental analysis, which is doing an analysis on individual securities,” he explains.

In times of extreme market volatility or substantial drawdowns, active managers are able to make changes to their portfolio at their discretion, says Sarah Abernathy, a senior investment analyst from Envestnet, a provider of integrated portfolio, practice management and reporting solutions. Additionally, incorporating active investing can also lead to excess return, she says. Active strategies are intentionally built by their managers to be different, with the intention of adding excess return or reducing risk relative to the benchmark. “This allows the potential for, but not the guarantee of, higher growth in assets over time compared to a passive strategy,” she explains.

The micro-management that comes with active investing means higher costs because it relies on the skill set of an investment manager that cannot be cheaply replicated by technology, says Abernathy. Active investing also has a higher potential for underperformance and higher volatility and lower capacity. According to Abernathy, these strategies tend to be relatively concentrated and therefore can reach capacity constraints that cause them to close to new investors. Active strategies will also have lower transparency because they rely on the skill set of the firm or management team, so their methodologies are largely kept proprietary and not published in the same manner as a passive strategy, she says.

Passive Investing

By definition, passive investing is an investment strategy to maximize returns by minimizing buying and selling. Index investing is one common passive investing strategy whereby funds purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon.

Passive investing is a long-term, buy-and-hold style of investing, where investors do not pay too much attention to short-term market movements and noise, says Nauman Anees, founder and CEO of ThinkMarkets, an online brokerage firm. “The main advantage of passive investing is that it does not require any micro-management and you make money if the price of the investment goes up from where you have bought,” Anees adds. Because there might be less buying and selling when investing passively, transaction and other costs will be low, he notes.

However, one of the largest disadvantages of passive investing is the potential to fall below entry and then remain low for multiple market cycles, which could tie up an investor’s capital, Anees cautions. “Worse still, is the potential to lose all your capital if the company you are investing in goes bust and you did not act quickly enough to limit the damage,” he says.

Mark Clure, a certified financial planner (CFP) and partner at Enso Wealth Management, echoes this warning, saying that while passive indexing has a lower cost structure, it can come at a higher price. “Since there is no management of the index fund, there is no adjustment during turbulent times, which can create anxiety for investors,” he contends. “Active managers attempt to produce greater returns than the index through better investment selection.”

Investors who want access to exposure in specific diversified portfolios may look to active management, says Cohen. “In some markets, particularly ones that are more illiquid and inefficient, it’s harder to access it cost-effectively in a passive manner. In private markets or private real estate, you can’t access that market passively,” he says.

Choosing Active or Passive Investments

Selecting the right types of investments for a DC plan investment lineup can be challenging. Abernathy recommends breaking down key considerations for each strategy. When evaluating passive investing, track errors relative to underlying funds. Performance differential over the long-term should be minimal, Abernathy notes. Plan sponsors should also consider costs and liquidity metrics for exchange-traded funds (ETFs).

Minimum key considerations for active strategies include reviewing the investment manager’s tenure (Abernathy recommends a period of at least a year), the investment’s risk-adjusted relative performance, length of track record (a suggested minimum of three years) and asset levels of the firm and active strategy.

Whichever strategy plan sponsors choose, it’s imperative to understand there is no right or wrong answer when deciding whether active or passive investing is right for the plan’s lineup, notes Clure. Instead, carefully consider costs, philosophy and the historical performance of each, he suggests. “Choosing an investment manager who has consistently outpaced the indexes will provide better real-world outcomes for participants,” he says. “Choosing an investment manager that has provided better outcomes than the market will make an enormous difference not only in accumulating wealth, but also during retirement when participants are drawing down their assets.”