Active, Passive Funds

Much discussion surrounding fund selection has focused on the performance of active fund management vs. investing in passive funds. While there are studies to support one tactic over the other, there will never be a definitive answer in which is effectively a better approach. A broadly diversified investment lineup could incorporate both strategies where investors are probably best served with a combination.

Active Funds

Active funds employ a portfolio investing strategy where the manager makes specific selections with the goal of outperforming an investment benchmark index. Active management is the opposite of passive management, because in passive management the manager does not seek to outperform the benchmark index.

Merits

  • there is the ability to react to market conditions and adjust a portfolio accordingly
  • each manager will use their own stock selection skills in their endeavor to outperform
  • managers will buy targeted stocks when they believe the price is right

Considerations

  • higher trading costs than passive funds as they have a greater turnover of holdings
  • an active fund could underperform the market

Passive Funds

Passive funds are managed with the goal of tracking or replicating the performance of the underlying index such as the S&P 500. Essentially, passive funds are designed to mirror the performance of the respective indices without entailing any forecasting.

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Merits

  • by tracking an index, an investment portfolio typically experiences fair diversification
  • they have lower trading costs than active managed funds as they have low turnover of holdings
  • they don’t require an active manager

Considerations

  • passive funds will never outperform the market
  • inability to move to cash in market contractions

Conclusion

Investors can enjoy the benefits of dual approaches when both active and passive funds have been included in the lineup. At times, active managers may outperform the benchmarks and capture some alpha in markets that tend to be less efficient while other times a passive fund will provide steady returns with low expenses.

Either way, an open-architecture design is the most versatile investment structure for employers because it enables freedom of choice.  American 401k is an open-architecture design.

Past performance does not have any indication for future returns.