When it comes to investing, the "active" versus "passive" management battle continues. What is it all about?
"Active" management describes investment advisors who think they can buy individual stocks and bonds that will perform better than the stock or bond market as a whole. For example, they buy Coca-Cola but not Pepsi, Apple but not IBM, or Macy's but not Target.
"Passive" management describes investment advisors who buy all of the securities in a market index in the proportion owned by the index. For example, they buy all 500 stocks in the Standard & Poor's 500 Index in the proportion that each stock is weighted in the index. The top five holdings would be Apple, Exxon Mobil, General Electric, Chevron and IBM. (Procter & Gamble is the eighth-largest holding, for those of you with Cincinnati roots.)
Investors Vote with Their Feet
In 2012, according to The Wall Street Journal, investors pulled about $120 billion dollars from actively managed funds, the largest yearly outflow since 2008, while pouring about $155 billion in to passively managed investments, the largest inflow since 2008.
Why Passive Management?
There are two key advantages to passive management.
"The advantages of passive investment management are hard to beat." [Tweet this]
- Cost. Passive funds have significantly lower management fees and expenses. According to The Vanguard Group, one of the largest passive fund companies, its passively managed funds are 82% less expensive than the industry average. This is particularly important for bond funds in a low-interest-rate environment.
- Diversification. Passive funds own more securities so there is less specific security risk. More important is the performance of stocks an actively managed fund doesn't own. If an actively managed fund doesn't own just a small handful of the top-performing stocks, it will under-perform.
The battle between active and passive management has raged for years and will continue to do so. The advantages of passive management, however, are hard to beat.
About Bruce J. Berno, CFP®
Bruce J. Berno, CFP® is the founder of Berno Financial Management, Inc. a fee-only comprehensive personal financial planning and investment advisory firm headquartered in Cincinnati, Ohio. Since 1993, Berno Financial Management has been helping individuals and families achieve financial peace of mind. For more information about Berno Financial Management, visit http://www.bernofinmgt.com.