Decades of research show the benefits of asset allocation using index funds. But new research suggests that many active strategies outperform over time, even after fees are taken into account.
Asset managers including John Hancock and Morgan Stanley have researched the active vs. passive question, as it's in their interest to determine the optimal return for their clients, balanced with the effect of management fees.
Unfortunately, all too often, that question is answered incorrectly. It's not an either/or proposition; the best long-term results come when you do both.
"Blending active and passive strategies can help investors outperform and pursue other important objectives while still being mindful of cost and tax efficiency," John Hancock analyst Leo M. Zerilli wrote in a white paper.
Active Investing
Active investing means putting your money into funds whose strategy is based upon managers' ability to pick investments deemed to have the potential to appreciate in value. In the past, active vehicles were exclusively the domain of mutual funds, but today it's easy to find actively managed ETFs as well.
In general, active managers strive to beat a particular benchmark. In addition, each fund has its own stated objective or philosophy.
For example, the Growth Fund of America (AGTHX), an active fund with $282.5 billion under management, "seeks opportunities in traditional growth stocks as well as cyclical companies and turnaround situations with significant potential for growth of capital," according to fund literature.
This fund consists mainly of domestic equities. Its benchmark is the S&P 500.
Passive Investing
Passive investors - and this includes many if not most clients of fiduciary financial advisors these days - you don't go through the process of trying to identify mispricings or securities trading at low multiples relative to their earnings.
Your goal is to get market performance, usually based on a broad swath of global indexes, and indexes representing various market caps and sectors. You typically wouldn't just buy an S&P index fund, such as the SPDR S&P 500 ETF (NYSEARCA:SPY) and call it a day. Instead, you just invest in a way that gives you broad market exposure.
However, many passively invested portfolios do consist of a collection of index funds, which is an easy and inexpensive way to generate market returns.
As you might imagine, active management is more costly, since stock-picking requires not only a manager but also research analysts. In addition, the higher frequency of trades adds costs. That's why actively managed funds have higher fees than index funds.