Active vs Passive Portfolio Management – Which Investment Strategy Is Right for You?

There is an active vs passive portfolio management debate that you may have thought about. Which is ideal for your needs? Here’s looking at both these investment strategies in more detail below.

What is Active Portfolio Management?

Active portfolio management is a more hands-on strategy for investments. In this case, investors or managers aim at surpassing the performance of particular market benchmarks, such as the Nifty 50 and others, instead of only replicating/mirroring them. This investment approach involves extensive research and frequent security trading along with market timing aspects. The goal is leveraging inefficiencies in the market and maximizing overall returns. 

However, the approach often comes with higher charges and risks in comparison to passive management. Some of the strategy components include technical and fundamental analysis along with economic forecasting. Sectoral rotation, risk management, and active buying and selling of securities are key approaches in this case. Managers often adjust portfolios dynamically to tap market opportunities or combat risks during market downturns. The expense ratios are usually higher due to trading and active research expenditure. 

What is Passive Portfolio Management?

Passive portfolio management is another type of investment strategy that aims at replicating or mirroring the performance of a market index, rather than aiming to surpass it. This is usually done with ETFs (exchange-traded funds) or index funds, leading to minimal trading activity, broader diversification, less management supervision, and lower costs. 

It is suitable for long-term investors who are inclined towards a buy-and-hold strategy for steady returns. This is something that you may keep in mind, since the ultimate active vs passive investing choice depends on your risk appetite and investment philosophy. So, in this case, the portfolio will have the same stocks as the selected benchmark index, and that too in the same proportion/weighting. Trades only happen when there are changes in the underlying index (stocks being added or removed) without any impact of market predictions. The expense ratios are lower due to less active research and infrequent buying/selling. Less frequent trading may also result in fewer tax events.

Key Differences Between Active and Passive Portfolio Management

Here’s looking at the main difference between active and passive portfolio management services. 

Advantages of Active Portfolio Management

While deciding on your active vs passive investment strategy, it is important to know the advantages of both. Some of the benefits of active portfolio management include: 

• High return potential- This is because active portfolio managers aim at surpassing the market benchmark and not just matching the same. They keep identifying securities that are undervalued and tap into inefficiencies in the market. 
• Higher adaptability and flexibility- Managers can swiftly adjust asset and sectoral allocation, along with individual holdings in response to changes in economic conditions. 
• Hedging and mitigating risks- Active management enables pro-active reduction of exposure to declining markets. Managers may also leverage instruments for hedging like options or even selling off high-risk assets. 
• Personalized strategies- Managers can customize portfolios based on the specific objectives of investors, risk appetite, and other ethical considerations. 
• Active management of risks- Portfolios are tracking continuously, enabling swift rebalancing to mitigate risks and manage volatility better. 
• Tax efficiency- There are several tax-efficient techniques used by managers for offsetting capital gains with losses. 

Advantages of Passive Portfolio Management

Passive portfolio management also has its fair share of advantages, including the following: 

• Lower fees/costs- Funds which are passively managed, i.e. ETFs or index funds, have considerably lower expense ratios and costs of transactions. This is because frequent trading and comprehensive research are not required in this case. 
• Better tax efficiency- There are lesser taxable events due to fewer taxable capital gains and infrequent trading. This boosts your net returns to a large extent. 
• Lower risks and steady returns- By monitoring the broad market index, the portfolio lowers the risks of underperformance in relation to the market. This ensures the delivery of returns that match the benchmark accurately.
• Broader diversification- Passive investment strategies help you get exposure to a diverse range of securities. This automatically lowers the risks linked to the failures of individual stocks/securities in the portfolio. 
• Simple operations and higher transparency- You will find it easier to understand passive portfolio management. You can set your strategy and hold on, since there is full knowledge regarding the assets which are exactly held in the index. 
• Long-term suitability- If you’re looking for steady returns in the long haul, this strategy works best. You do not have to track market fluctuations constantly in this case. 

Disadvantages of Active Portfolio Management

Some of the disadvantages of active portfolio management include the following: 

• Higher fees/costs- Active management comes with comprehensive research and frequent trades. This leads to higher management costs and brokerage commissions, along with trading charges. They all eventually eat into your net returns. 
• Underperformance risks- Several active managers often fail to surpass the benchmark index over time, once higher fees are taken into account. 
• Lower tax-efficiency- Frequent selling and buying often leads to higher STCG (short-term capital gains). They are naturally taxed at higher rates in comparison to gains in the long term. 
• Performance inconsistencies- The performance of the portfolio is heavily dependent on the skills of the manager. This may sometimes be inconsistent or suffer from incorrect market timing and poor/biased selection, thereby leading to major losses.
• More time involvement- Active portfolio management requires constant tracking and research, along with swift decision-making, which is hugely time consuming. 
• Possibilities of human errors- Active managers may sometimes make mistakes, due to their emotions or biases influencing their decisions. They may also fail to forecast market movements at times. 

Disadvantages of Passive Portfolio Management

The disadvantages of passive portfolio management include: 

• No outperformance possibilities- Passive portfolios only match the benchmark index without surpassing it. You can thus expect market-average returns (after deducting the fees) in many cases. 
• Zero adaptability or flexibility- Passive managers do not make tactical/strategic decisions to bypass downturns, sell assets that underperform, or leverage short-term market opportunities. 
• Total exposure to market downturns- Since these portfolios replicate specific indices, they keep mirroring the same during market downturns. This leads to considerable losses rather than switching to safer securities. 
• Concentration risks- Several indices are also weighted by market capitalisation. This means that a few big companies may dominate investment portfolios, leading to higher risks in case these particular stocks perform poorly. 
• Tracking errors- Passive funds may not ideally replicate the index at times owing to tracking errors. This may lead to returns deviating a little from the target benchmark. 
• Blind investing approach- Passive funds may sometimes purchase all the securities in the index, irrespective of their fundamentals and individual value. This may lead to holding stocks that are overvalued in some cases. 

Also read : Risks of Investing in Portfolio Management Services

Performance Considerations – Active vs Passive

Which is better, active or passive investing? They represent two different approaches towards portfolio management, with major differences in performance (after accounting for return potential, risks, and costs). Here are some key aspects worth noting in this regard. 

• Potential for returns- Active funds aim to generate alpha (returns surpassing the benchmark) through market timing and research. Passive funds aim for returns in sync with the market, thereby accepting performances that are average. 
• Expense ratio/costs- Passive funds have considerably lower costs due to lower trading and research. Active funds have higher expense ratios between 0.5-2.5% which may eat into your net returns. 
• Risk profile- Active funds may have higher volatility and risks since they depend on the judgment of the portfolio manager. Passive funds usually offer wider diversification and lower risks of underperformance. 
• Tax efficiency- Tax efficiency is often higher for passive funds, since they hold securities for longer periods. This leads to lesser distribution of capital gains. 
• Market efficiency aspects- Active management usually ensures better performance in niche or less-efficient markets (emerging/small-cap). Passive strategies perform better in more efficient markets (large-cap). 

Cost Comparison – Active vs Passive Investing

When it comes to active funds vs passive funds, you should compare the costs beforehand. Here are some key pointers in this regard. 

• Expense ratio- Passive funds (ETFs/index funds) usually have expense ratios between 0.03-0.20%. Active funds, in comparison, have expense ratios between 0.5-2.0% annually. 
• Costs of transactions- Active management comes with higher costs for frequently purchasing and selling securities (transaction costs), brokerage commissions, and taxes. Passive funds have minimal turnover and lower costs. 
• Fee impact- A fee of 0.15% for a passive fund may lead to a difference of about 1.4% in annual returns, if you consider a fee of 1.5% on active funds. These compound considerably over more than 10 years, thereby lowering net growth. 
• Performance fees- Some active funds may have added performance fees for surpassing target benchmarks, thereby enhancing the total ownership costs. 

Risk and Volatility Comparison

A deeper look into the active vs passive portfolio management debate is essential from a volatility and risk standpoint. Active management may be a high-risk affair owing to market timing and concentration aspects. Passive portfolios usually have lower volatility since they replicate broader indexes. Active managers depend on their skills to outperform indexes, thereby leading to higher volatility. Passive strategies offer returns in sync with the index, thereby lowering the risks of underperformance in comparison to the market. 

Active management strategies may aim to mitigate overall volatility in bear markets, while passive strategies may prioritize staying invested, accepting the market-driven volatility. 

Tax Efficiency – Active vs Passive

Passive, index-tracking trade rarely, leading to lesser capital gains distribution. The buy-and-hold long-term approach also helps investors to either avoid or delay capital gains taxes. This ensures better rates on long-term capital gains. ETFs are often more tax-efficient as compared to mutual funds owing to in-kind redemptions. These avoid the sale of securities that otherwise trigger taxable gains. 

High turnover is a feature of active portfolio management (80% annually), leading to higher short-term capital gains (taxed at higher rates). Active managers may mitigate taxation liabilities through loss harvesting (selling off underperforming stocks) to offset the gains. This may improve the post-tax returns at times.

Who Should Choose Active Portfolio Management?

So, when to choose active vs passive portfolio management? Active portfolio management is ideal for investors who wish to outperform the market benchmarks and are okay with taking more risks and paying higher fees to potentially earn superior returns. This is suitable if you have short-to-medium-term objectives along with higher risk tolerance and a need for customized, actively tracked, and more flexible investment portfolios. 

This approach also works well if you have a firm belief in specific sectoral inefficiencies and believe in the ability of the fund manager to identify mispriced securities and act accordingly. HNIs (high-net-worth individuals) with a sizable investment corpus usually prefer this strategy than passive approaches. It is not for those who want lower costs and higher tax-efficiency. 

Who Should Choose Passive Portfolio Management?

Passive portfolio management suits you if you’re looking for a long-term plan with steady, low-cost, and market-matching returns with lower efforts. You can use the strategy to gradually accumulate wealth or plan for retirement. It is a hands-off and tax-efficient blueprint that does not have the emotional pressures of trading actively. 

It will suit you if you are more inclined to lower expense ratios and lower costs of transactions. This also works if you lack the time and expertise to continually track markets, do your research, or make frequent trading decisions. Beginners and amateur investors may also find this strategy more viable, while it may help you get more tax savings in the bargain. 

Can Active and Passive Strategies Be Combined?

Active and passive portfolio management strategies may sometimes be combined to build a more hybrid and inclusive approach. This balances affordable and market-mirroring returns with more strategic opportunities for active and growth-oriented alpha. You can thus fuse the stability that passive investments ensure with the future potential for higher returns from actively managed securities. The overall expenditure stays lower, while there is customization based on your goals, market conditions, and risk appetite. 

In this case, you may choose low-cost and passive index funds/ETFs along with actively managed satellite positions or thematic securities with high future potential. Use passive funds for efficient markets and active funds for less efficient ones. Dynamically shifting between passive and active options may also help, depending on economic forecasts and changing market conditions. 

Conclusion

As you can see, the active vs passive portfolio management debate is a valid one. Both these strategies come with their own advantages and disadvantages. You can consider either one depending on your preferences or opt for a hybrid approach instead.