There is much debate these days over the value of active management in investment portfolios. Does one really need to hire an investment manager to select which stocks and bonds to invest in? Afterall, it was back in the 1970’s when Vanguard first pioneered the importance of passive or index investing. The late Jack Bogle, and founder of Vanguard, stated in his thesis at Princeton University that “mutual funds should make no claim to superiority over the market averages”. His ideas would eventually catch on and lead to the passive ETF industry we have today.
Not to make things too complex, this debate is not about two mutually exclusive ideas. A purely passive approach would be to buy the S&P 500 or some other index and never make any changes. And a purely active approach would be to routinely evaluate, buy and sell individual stocks. But an active investor could use passive funds like ETFs. Perhaps you think the energy industry will outperform this year, so you buy an ETF that captures the entire market. The main concept behind passive investing is that the investor is not deliberately including or excluding a certain security. The portfolio invests in the entire “market”. How big the market is and what investments should be included depends on context.
Active investors usually believe they can achieve one of two things, or both. The first is to “outperform” the market. Some investors believe that there are inefficiencies in the market that a savvy investor can take advantage of. The other is to manage risk levels in a portfolio. For example, many retired investors use bonds to mitigate risk in their portfolios. Bonds can be very complicated because they typically have two sources of return: price appreciation, and income. Because of this, some would argue that an active approach is more suitable when bonds are in included in the portfolio.
To be clear, it is not usually about choosing one or the other. Most strategies use a blended approach, and which specific strategy you use will depend on your risk tolerance, philosophies, and the type of investment to name a few. If you are young and want to take on lots of risk in your 401(k), a passive approach is very appropriate, in my opinion. If you are older and are looking to customize your portfolio to mitigate risk, a more active approach could be more suitable.
All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance does not guarantee future results.
Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met.