What is Foolsaurus?

It's a glossary of investing terms edited and maintained by our analysts, writers and YOU, our Foolish community. Get Started Now!


Active vs. Passive Investment Management

Original post by Natasha Gilani of Demand Media

Active and passive investment deal with managing financial securities.

Active and passive investment management are two different strategies investors use for financial instruments. Active investment management is when fund managers or investors use research, assumptions and forecasting tools to determine which investment instruments to buy and sell. Passive investment management, on the other hand, holds that there is a better chance of making profits if securities that replicate the performance of a particular benchmark index are purchased and held.

Strategy

Active investment management attempts to outperform the market by investing in securities that may potentially generate higher returns. Experienced fund managers manage active funds, and the success or failure of an active fund depends on the skills of the manager. Passive investment management takes a safer approach to investing and attempts to simply replicate the performance of a benchmark, writes Russ Koesterich in his book, “The Ten Trillion Dollar Gamble.” What this means, according to the author, is that a passive investor who runs an S&P 500 fund will own all the securities in the exact same proportions as those that make up the S&P 500. The resultant passive portfolio, therefore, will fluctuate in the same manner as the S&P 500 index will.

Fees

Actively managed investments typically charge more than passive investments, writes Robert E. Lawless in “The Student’s Guide to Financial Literacy.” Active fund managers use significant time and resources to research specific securities and companies before finally choosing which instruments to hold onto and which to sell. Passive investment management does not need professional fund managers or expensive support staff. Computers, which are programmed to find appropriate instruments based on investor requirements, do most of the work.

Diversification

Passive investment management allows investors to have diversified portfolios of investments, write the authors of the book “Portfolio Theory and Performance Analysis.” Diversification is important because it allows investors to reduce portfolio risk by investing in many different types of instruments. Active investment management relies on investing in those securities that are expected to perform better. Since there are only a limited number of such securities, active funds typically are less diversified than passive funds, and are therefore more risky.

Uses

Passive investment management is common in the equity market or the stock market. Investors invest in bond index funds and stock index funds. Active investment management is used when investing in large-cap value or blue chip companies and managed bond and stock mutual funds.

                   

References

  • "The Ten Trillion Dollar Gamble"; Russ Koesterich; 2011
  • "The Student's Guide to Financial Literacy"; Robert E. Lawless; 2010
  • "Portfolio Theory and Performance Analysis"; Noël Amenc, et al.; 2003

About the Author

Natasha Gilani is a published writer and Web content developer who has been writing since 2004. Her work appears on various websites, including FinWeb and DoItYourself, and she is a member of the Canadian Writers Association. Gilani holds a Master of Business Administration in finance and an honors Bachelor of Science in information technology from the University of Peshawar, Pakistan.

Photo Credits

  • Comstock/Comstock/Getty Images

Advertisement