When you embark on your investment journey, you’re faced with a plethora of terms and jargon that you must quickly grasp to avoid rookie mistakes. One crucial set of terms to understand is passive and active management. Active management occurs when an investor or portfolio manager handpicks the investments in their portfolio, whereas passive management involves selecting investments because they are part of an index. Each approach has its own philosophy and methodology, with supporters and critics on both sides.
Active management entails a hands-on approach to selecting and managing investments, often focusing on individual stocks. However, some mutual funds have an active portfolio manager selecting the underlying assets. Individual investors, fund managers, investment advisers, research analysts, and brokers engage in active research, analysis, and decision-making to outperform a specific benchmark index, such as the S&P 500, by using their judgment in selecting individual securities and deciding when to buy and sell them. They may also aim to control a portfolio’s overall risk by temporarily increasing the percentage devoted to more conservative investments. An actively managed portfolio allows its manager to consider tax implications by harvesting capital losses to offset any capital gains realized by its owner or time a sale to minimize any capital gains. This approach can lead to higher fees because of the active management and research involved.
In contrast, passive management seeks to replicate the performance of a specific market or sector index rather than trying to outperform it. This strategy is often used by mutual funds or exchange-traded funds (ETFs), which aim to match the performance of an index or sector by holding the same securities in the same proportions, eliminating the need for individual stock selection. The primary benefit of index funds is instant diversification. These funds typically track a specific market index, such as the S&P 500 or the FTSE 100, providing exposure to all the securities within that index and spreading your investment across multiple companies or issuers.
Passive management funds and ETFs generally have lower fees than active management, as they require less frequent trading and research. However, with a passive strategy, you invest in both high-quality and low-quality stocks included in the index, which can expose you to more risk than investing in a portfolio of only higher-quality companies. Another drawback of passive investing is participating in buying high and selling low. As a stock’s price rises, its market capitalization also rises, increasing its weighting in the index. To maintain the objective of tracking the index, the fund must buy more shares of that stock at the higher price.
Financial advisers often guide clients through the decision-making process, considering the client’s overall financial plan, goals, risk tolerance, and investment timeline and then develop a strategy to achieve those goals. The adviser then recommends investments that align with the client’s customized strategy, often using a combination of actively and passively managed investments. A qualified financial adviser can help you navigate these considerations and assist you in monitoring costs and tax implications.
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This article is for demonstrative and academic purposes and is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
