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Revisiting the Debate: Active vs. Passive

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Key Points

  • Passive investing, through index mutual funds and ETFs, has been the focus of investor and media attention in recent years.
  • We believe that active management continues to offer numerous opportunities, particularly in select markets or during volatile market conditions.
  • Most portfolios can benefit from a combination of both approaches; here we discuss some of the considerations in making the determination. 

Over the past several years, particularly given the explosive growth in index-tracking exchange traded funds (ETFs), passive investment strategies have received the lion's share of both investor and media attention. While a strong argument can certainly be made in favor of passive investing, we believe that active investing—with its potential for both upside performance and downside protection—still has a place in many investors' portfolios.

Yes, the advantages of passive investing compared to active are easily quantified: broad market exposure, tax-efficiency and, of course, low expenses. Investors whose criteria are strictly price-related will be hard-pressed to pick an actively managed fund over an index fund. However, perhaps the active/passive debate should be re-couched: not which is better?, but does it ever make sense to pay a higher fee for an actively managed fund, and if so, when?

Key Distinctions Between the Approaches

To review: Passive management generally refers to the use of index funds or ETFs, which seek to mirror the performance of a particular market benchmark ("index") by holding all—or in some cases a representative sample—of the securities in that benchmark. Actively managed funds, on the other hand, seek to outperform their benchmark and/or peer group through a combination of research, market analysis and forecasting. Active management stems from the belief that markets are not always efficient and that it's possible to uncover and profit from information that may not be reflected in a security's price.

When to Consider Active Management

Despite the appeal of index funds, actively managed funds offer some notable advantages, particularly at certain times and for certain strategies. In turbulent markets, for example, actively managed funds can be nimble to take advantage of opportunities unavailable to those chained to a benchmark index. And they can offer downside protection as well by avoiding volatile areas of the market or shifting into defensive positions when markets grow turbulent. 

But perhaps instead of the persistent "either/or" argument, it makes sense to consider both—a mix of actively managed and passive funds to take advantage of the strengths of the different approaches. It's important to note that active managers may fail to outperform or effectively manage risk in the portfolio. Here are some things to consider.

  • Market Efficiency

Given the premise of efficient markets—that publicly available information is already embedded in the price of most securities—it's not easy to identify mispriced securities with the potential to outperform. While large, highly liquid, developed markets are generally quite efficient, others are less so—such as emerging or frontier markets or smaller industry or sector niches, where a skilled portfolio manager may be able to uncover promising securities not recognized by an index.

  • Outperformance Potential

Many investors are satisfied if their portfolio simply mirrors the performance of one or more indexes. Others, however, appreciate the opportunity to outperform or—in the case of a falling market—to limit losses. Because of their ability to shift gears, change course, or seize an opportunity in response to fluctuations in the market or economy, actively managed funds offer the potential—though certainly not the guarantee—of surpassing market returns. 

  • Volatility

Passive funds inherently reflect the sometimes gut-wrenching swings of the index they track. While stomaching volatility can at times be challenging for index investors, for active managers, it creates opportunity—to buy into appealing prospects or eliminate positions they feel are overvalued. In some cases, actively managed funds can be more risk averse than index funds, given their ability to nimbly adjust to market forces. 

  • Access to Unique Insights or Market Niches

A number of actively managed funds offer potential for better results—for instance, through a particularly insightful manager, a singular investment premise, or a laser focus on a specific market niche. In smaller markets, index funds and ETFs are sometimes forced to own large positions in just a handful of the biggest companies, potentially limiting diversification. And in some smaller corners of the market, suitable passive vehicles may be hard to come by. In just about every possible investment theme, however, talented active managers may be found.

  • Boosting Fixed-Income Yields

Bond indices tend to be heavily weighted toward Treasuries and other U.S. government-back bonds, which these days are providing paltry yields to fixed-income investors. In addition, such holdings are subject to interest-rate risk—the risk of lower prices if and when interest rates finally rise. By having the flexibility to seek out individual issues in a wide swath of the bond market as well as the ability to avoid certain sectors, active managers of fixed-income funds can offer the potential for greater yield.

The Bottom Line

Investors must determine for themselves how best to accomplish their goals without taking undue risk. But "undue risk" can be thought of in different ways—risk of a falling market; risk of volatility; risk of missing out on potential gains. Remember, market shifts are inevitable—and impossible to predict. For investors willing to take on the incremental risk in exchange for the potential of outperformance and tempering losses, a strong case can be made for active management, particularly in the context of a fully diversified portfolio that also incorporates passive approaches.

Considerations in Selecting Active Funds

  • Consider active management for foreign shares and/or smaller niches of the market, such as emerging or frontier markets or sector or industry exposure.
  • Consider active management of bond funds, particularly in environments such as today's, when bond yields are low by historic comparison.
  • Look for funds that demonstrate skill and conviction without simply emulating an index.
  • Look for funds with long track records over various market cycles. If you're particularly concerned about potential losses during downturns, look for funds that have historically exceled during difficult markets, which can be measured by downside "capture ratios."
  • Seek reasonable costs. Yes, active management generally costs more than a passive approach, due to the research and analysis required to select underlying investments. If you compare costs across funds within the same asset class, you'll get a sense of what's considered a reasonable expense ratio.
  • Keep taxes in mind. Actively managed funds are subject to greater tax liabilities than index funds because of more-frequent buying and selling, thereby generating capital gains. If you have tax-deferred or tax-free retirement accounts, consider keeping your active investments there.

Need help picking funds?

Spotting outperformers isn't easy. For investors seeking to incorporate active management into their portfolio for maximum diversification, Schwab's Mutual Fund OneSource Select List® can help. It lists Charles Schwab Investment Advisory's top picks in multiple categories of funds its analysts expect to outperform their peers in the forthcoming one to three years. The Select List's underlying research incorporates both qualitative and quantitative selection criteria, including expenses, historical track record and assets under management.

Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by clicking Investor Information or calling 800-435-4000. Please read the prospectus carefully before investing.