The following is a primer for investors who may not be familiar with the terminology or concepts of passive management.  For a more in depth analysis, please refer to any of the excellent books recommended at the end of this article.

At its most basic level, “active” investing refers to the attempt to outperform some index, for example the S&P 500.  “Passive(1)” investing, involves investing to match an index.  This may mean purchasing all the stocks in an index or an optimized subset.

For simplicity’s sake, let’s focus just on stocks.  Active investors typically employ one or more of the following methods in an attempt to “beat the market:”

•Choosing stocks expected to outperform

•Choosing active mutual funds expected to outperform some benchmark

•Timing the market by moving money into or out of stocks (or mutual funds) based on one’s perspective of how the market is expected to perform

If active investing seeks to outperform and passive investing seeks to match the market, why wouldn’t everyone want an active approach?  The reason is simple: Decades of research have produced a mountain of evidence that active management underperforms.  The price of a stock reflects the information currently known to the marketplace.  This is referred to as the Efficient Market Hypothesis.  A more advanced discussion of these issues can be found elsewhere.

Neither you nor a professional money manager can consistently choose stocks that outperform.  Nor can you or anyone else time the market.  Attempts to do so are expensive.  The costs associated with active management, such as personnel and research, get passed on to you in the form of high management fees.  In addition, the much higher turnover associated with active managers results in significantly higher trading costs.  Furthermore, active management is, on average, much less tax-efficient, due to its higher turnover.  Over time, pursuing an active strategy virtually guarantees that an investor will underperform the market. 

In contrast, passive management allows you to consistently capture the returns of the particular asset class.  Properly implemented, passive management has lower fees and lower turnover.  It allows you to focus on asset allocation, a much more significant factor in a portfolio’s performance.  Additionally, an effective passive approach should be coupled with disciplined rebalancing, an attention to fees and tax awareness.

Of course, like most things in life, the distinctions between active and passive management are not always so clear.  For example, an investor actively decides as to what asset classes to invest in and in what proportion.  For a more thorough, and at times entertaining, discussion of these concepts the following books are highly recommended:

•William J. Bernstein, The Intelligent Asset Allocator (McGraw Hill 2001)

•Charles D. Ellis, Winning the Loser’s Game (McGraw Hill 2002)

•Burton G. Malkiel, A Random Walk Down Wall Street (W. W. Norton 2007)

(1) Sometimes known as index investing or equilibrium-based investing