The active vs. passive investment debate

It’s been a subject of ongoing discussion and debate within the investment world for many years. Which are more effective—actively managed funds or passively managed funds? Get answers to these investing basics below.

In an effort to outperform a particular benchmark index like the S&P 500® or the Nasdaq-100 Index®, managers with an active investment strategy will overweight or underweight certain stocks in their portfolio. They may also opt to hold securities not part of the benchmark, or tactically move assets into and out of cash as they deem appropriate. Because of this more hands-on approach, active management generally carries higher fees.

With a passive investment strategy, managers generally seek to precisely mirror their benchmark index’s holdings and are therefore able to charge lower fees. Typically, however, they don’t have the freedom to move into cash, or the ability to quickly raise funds in the midst of a market downturn to take advantage of opportunistic, tactical strategies.

A strong argument for both

Ever since the 2008 financial crisis, there’s been far more fiscal and monetary policy coordination between central banks around the globe—causing global economies to become more closely aligned and moving in unison. Not only did differences among individual economies diminish, but differences among individual companies did as well—with lower interest rates somewhat leveling the cost of capital playing field. The result has been greater and greater correlation among individual stocks—making it increasingly difficult for active managers to generate additional alpha through security selection.

The ability of managers to beat their benchmarks with an active investment strategy varies widely from asset class to asset class. In some instances where there’s high transparency and readily available information (e.g., large cap core, large cap growth and mid cap), only a small percentage of active managers succeed. In other cases, however, where market information and transparency aren’t as widely disseminated (e.g., foreign and emerging markets, alternatives and fixed income), an active investment strategy may often be able to deliver sizable outperformance relative to their benchmark index.

There’s also anecdotal evidence suggesting that active managers have a greater potential to outperform passive strategies when markets are highly volatile. Look no further than 2020—one of the most volatile years in history—where nearly half (49%) of the roughly 3,500 active funds were able to outperform their average passive counterparts.¹ This is due in large part to manager discretion; being able to overweight or underweight certain securities, as well as being able to temporarily shift a greater percentage of fund assets to cash.

The case for passive investing, however, is equally compelling—but for different reasons:

1. Fees — All things being equal, passive investing is considerably less expensive than active investing. According to a recent Morningstar fund fee analysis, fees for actively managed U.S. equity funds average 0.68%, while passive funds average just 0.09%.² Over an extended period of time, this 0.59% annual expense ratio difference can have a significant impact on your portfolio’s total return.
2. Tax efficiency — Since passive managers are merely replicating the holdings of a benchmark index, they tend to sell securities far less often than active managers who must periodically sell shares to meet fund redemptions and also regularly buy and sell shares to overweight or underweight holdings in an effort to generate excess returns. This higher rate of portfolio turnover by active managers tends to be far less tax-efficient—producing both long- and short-term taxable gains.
3. Portfolio transparency — Because passive managers are simply tracking their benchmark index, there are no proprietary investment strategies they feel compelled to keep under wraps. They therefore can be fully transparent as to their portfolio holdings, weightings, etc. Conversely, active managers often justify non-disclosure of their holdings to protect proprietary investment ideas.

When you invest with Invesco, you’re partnering with a firm that puts you and your needs first. We ultimately believe investors may be best served by seeking out active managers in situations where the manager can potentially add value on a risk-adjusted basis. However, for other asset classes and/or sectors where markets are transparent and information plentiful (such as large cap growth), low-cost passive index strategies like the Invesco QQQ ETF could make more sense over the long term.