The Difference Between Passive vs Active Portfolio Management

by Alina Khan

Published On Aug. 12, 2023

In this article

One of the biggest debates in investing is whether it's better to actively manage a portfolio or if we should take a more passive approach. Each method has its own advantages and disadvantages; what it comes down to is about the different types of investors and their comfort with risk. Let’s dig a little deeper into both active and passive portfolio management, we will look at their strategies, advantages, and other important things to factor in when choosing between active or passive investing.

What is Passive Portfolio Management

Passive portfolio management is all about making a portfolio that looks similar to a certain market index or benchmark. Main goal is to copy how the market performs and not necessarily to do better than it. Managers of passive portfolios don’t track how individual investments are doing, they don’t continuously monitor and change the constituents of a portfolio. The idea is simple - keep it the same as what's present in the index or the benchmark we are following.

Advantages of Passive portfolio management:

  • Low Costs: Passive management typically involves lower fees and expenses compared to active management since trades are limited in nature and analysis is only to the extent of what is comprised in the benchmark index - so transaction costs are minimal.

  • Consistency: Passive portfolios provide consistent exposure to the broader market, reducing the impact of market fluctuations on the portfolio's performance.

  • Tax Efficient: Less trading also means less short term capital gains are incurred which means, passive portfolios are more tax-efficient than active portfolios

  • Diversification: Since investing in passive strategies involves adding constituents that are the same as the benchmark or the market index, it inherently provides higher diversification benefits

  • Accessibility: Index funds and exchange-traded funds (ETFs) both use passive management strategies that are widely available, easily accessible and have lower minimum investment requirements - as low as Rs.500 for some SIPs.

Disadvantages of Passive portfolio management:

  • Not built for Outperformance: Passive funds aim to match the benchmark index’s return but will in most cases never outperform it since the passive portfolio just copies the index

  • Lack of Customization: Each passive fund is built targeting a specific index like the Nifty50 which looks at the top 50 stocks in Nifty or Nifty Smallcap 100 which looks at the top 100 smallcaps stocks in the Nifty. As such, investor’s specific needs and preferences cannot be catered to with an index as there is no room for customization.

What is Active Portfolio Management

Active investing is the opposite of passive portfolio management - the objective is to beat the market or a specific market index/ benchmark like the Nifty50, BSE500 or Nifty Smallcap 100 - the exact benchmark will depend on the active management strategy that is used. Active portfolio managers are hands-on, they decide what investments need to be added and removed from a portfolio. They use research, data, conduct fundamental/ technical analysis and what they know about the market to find good opportunities and change what's included in the portfolio.

Advantages of Active Portfolio Management

  • Potential for Higher Returns: Active managers exploit market inefficiencies, select high-performing securities, and time their trades to beat the market

  • Tailored Strategies: Based on the investor’s specific investment goals, risk tolerance, and overall market trends, Active managers can create customized portfolios that suit the investor

  • Flexibility: Active managers can quickly adapt to changing market conditions, reallocate assets away from riskier to safer assets or vice versa, and accordingly select securities and assets

  • Risk Management: Quicker response time from active managers, means they can respond to market conditions faster than passive managers and can even, reduce risk by re-adjusting allocations to more conservative investments. All of this may help minimize losses during market downturns.

  • Tax Considerations: Active managers can time selling assets and securities that are in their portfolio to reduce capital gains or employ loss-harvesting strategies for getting tax benefits.

Disadvantages of Active Portfolio Management

  • Higher Costs: Actively managed portfolios often have higher trading costs due to frequent transactions.

  • Limited Flexibility in Mutual Funds: Actively managed mutual funds may have constraints that limit the manager's ability to pivot or adapt to market changes.

Passive Portfolio Management Strategy

Passive portfolio management involves selecting index-based funds or exchange-traded funds (ETFs) that replicate the performance of a particular index. These funds mirror the asset allocation of the chosen index and require minimal ongoing management. The goal is to achieve market-like returns, making it suitable for investors seeking long-term growth with lower costs. Let’s go through a few of them -

1. Index Investing

Index investing involves mirroring a particular market index, such as the Nifty50, BSE300 etc. Investors get exposure to the market's performance at a low cost. However, there is limited or no chance for outperformance and investors do not have any way to customize these indices.

2. Strategic Asset Allocation

Strategic Asset Allocation is achieved by diversifying across different asset classes such as bonds, stocks, and cash to mitigate risk and achieve more stable returns. Tailoring to individual risk tolerance and investment goals allows for better risk management. This is a longer term strategy that again focuses on limited trading - however it does require ongoing monitoring and adjustments, and may lack potential for higher returns.

3. Buy-And-Hold Investing

Buy-and-hold is a long-term investment strategy that focuses on buying and holding quality assets with the objective of limited/ minimal trading. The benefit is that it reduces transaction costs and taxes. By holding quality assets for longer time periods, we are relying on letting compounding returns provide long term benefits. However, the strategy can be impacted if the selected assets underperform.

Active Portfolio Management Strategy

Active portfolio management involves undertaking detailed research and analysis, of securities and ongoing monitoring of market conditions - all of this provides significant in terms of what they actively focus on buying and selling securities. Active portfolio management focuses on generating alpha returns by not just outperforming the benchmark index, but also capitalizing on mispriced securities or market inefficiencies to generate excess return or alpha.. Let’s go through a few of them -

1. Fundamental Analysis

Fundamental analysis requires evaluating a company's financial health and growth potential by analyzing their financial statements, competitive advantages, corporate governance issues etc. The aim is to come up with an intrinsic value of the asset which can then be compared against the market value to determine if an asset or a security is under valued, par or over valued. Under-valued stocks can be buying investment opportunities and over-valued stocks can be good selling investment opportunities. However, this approach is not just time-consuming, but it really depends on the inputs such as the quality of the information available that goes into deriving the intrinsic value.

2. Technical Analysis

Technical analysis focuses on analyzing historical price and volume data to identify patterns and trends. It is useful for short-term investment strategies and can signal buying or selling opportunities. The focus is on identifying patterns in the charts and the data and not on any information that is concerned with the fundamentals of the business or broader macro economic trends.

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Key Differences Between Active and Passive Portfolio Management

Let's look at the main differences between active and passive portfolio management to understand how they work -

Active Management

Passive Management

Attempts to beat benchmark performance

Attempts to match benchmark performance

Contends pricing inefficiencies in the market create investing opportunities

Contends that it is difficult or impossible to "beat the market"

Securities selected by portfolio manager

Securities selected based on an index

Focuses on choice of specific securities and timing of trades

Focuses on overall sector or asset class

Trading and the degree of liquidity for individual securities may increase portfolio costs

Infrequent trading tends to minimize portfolio expenses

Active management sounds good because it might give you more money in the end and lets you make specific choices. However, Passive management is simpler, cheaper, and you just follow the market - if in the long term the market grows (which we mostly expect it to), then passive management will also give good returns. The decision between the 2, depends on how much risk you're comfortable with, what you want to achieve, and if you think active or passive strategies work better.

Factors to Consider in Choosing Between Passive and Active Management

Investment Goals

Passive management is suitable for long-term investors that want stable growth at lower costs. Active management is more appealing to those looking for higher returns and want more involvement in the investing process.

Risk Tolerance

Passive management aligns better with risk-averse investors, while active management is more suited for individuals who are willing to take on higher risk for potentially higher rewards.

Time and Involvement

Passive strategies needs less monitoring and less involvement - suitable for investors with less time or interest in active decision-making.

Market Conditions

Active management may perform better in certain market conditions, such as periods of high volatility or when market inefficiencies are more pronounced.

Decision between Active or Passive Investing

Whether you decide between passive or active portfolio management comes down to what you personally like, how much risk you're okay with, and what you want to do with your investments.

In short, passive management is good if you want something simple, diverse, and affordable. It works well for people who want their money to grow in the long run without the need to make a lot of active choices. Active management is for people who think skilled managers can do better than the regular market.

The choice should really match what you want to do with your money, how long you're planning to invest, and how comfortable you are with it. You can even use a mix of both strategies in your portfolio to get the benefits of both.

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  1. Which approach typically has lower costs, Passive or Active Management?

Passive management typically has lower costs compared to active management. Passive strategies involve minimal trading and research, resulting in lower transaction fees and management expenses. Active management, on the other hand, requires ongoing research, frequent trading, and managerial expertise, leading to higher costs.

  1. Can Passive Portfolios outperform Active Portfolios?

Passive portfolios aim to replicate market returns rather than outperform them. While they may not consistently outshine active portfolios, they can offer competitive performance with lower costs over the long term, especially in efficient markets.

  1. Why do some investors prefer Passive Portfolio Management?

Some investors prefer passive portfolio management due to its simplicity, lower costs, and long-term focus. Passive strategies align well with investors seeking consistent market returns without the need for frequent decision-making or extensive research.

  1. Is Active Portfolio Management riskier than Passive Management?

Active portfolio management can carry higher risk due to its potential for misjudged investment decisions, higher turnover, and exposure to market fluctuations. Active managers' ability to outperform the market depends on accurate predictions and timely decisions.

  1. Can investors use a combination of both passive and active strategies?

Yes, investors often use a blend of both passive and active strategies in their portfolios. This approach, known as "core and satellite," combines the stability of passive investments with the potential for higher returns through active management. Passive investments form the core, while active strategies make up smaller satellite portions.

  1. Do passive investments guarantee positive returns?

Passive investments do not guarantee positive returns, but they aim to closely replicate the performance of a specific market index. The actual returns depend on the index's performance. Market downturns or poor index performance can lead to negative returns for passive portfolios as well.

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