Active management and passive management is one of the most heavily debated questions in the asset management business. The question of whether a skilled asset manager is capable of consistently beating the broad market has important implications. If you can make more by investing with a skilled manager, choosing the right manager becomes of paramount importance. If passive management is your methodology choice, you will need to examine the long term effects of how you invest because the methodology will be different. While different schools of thought reach opposing conclusions, understanding the arguments that will help you to make the best decision are important.
The Mechanics of Passive and Active Management
Passive management means that you select in a broad market index and invest your capital in those markets. This can be accomplished through an ETF or a mutual fund, but the defining feature is that you buy the entire market. In this way, your returns will mirror what the stock market does as a whole. You do not make any changes to your portfolio, instead you passively follow the market.
Active management seeks to outperform the broad market in a variety of ways. This approach may be as simple as investing in certain stocks within the index, or as complex as pursuing a statistically-driven investment model that regularly trade in and out of positions. In either case, the defining feature is that a manager is making active decisions as to what instruments should be included and in what relationship. The performance of the portfolio will be affected by the return of the general market, but the difference between your return and the market return will be attributable to active decisions.
Research has shown that over the long-run, active managers underperform the broad market when making only long term investment decisions. Active managers underperform the broad market over the long-run, but the investment horizon that you prefer may be different. More importantly, the average manager underperforms, but some managers outperform. There are some asset managers that consistently outperform the market, and some that consistently underperform. Picking which manager will produce the best returns is very difficult.
Not all asset managers pursue long-only investment strategies. Hedge funds, for example, may give you short exposure to various market segments. These managers are less correlated to the general market and their returns are harder to analyze. All in all, the research is inconclusive on which is the best approach to take, so you will have to customize it to your personal level of risk.
How to Proceed
Based on the available research, the most reasonable conclusion is that a skilled manager can consistently beat the market, particularly if they take more than long-term exposure. Given this, a blended allocation between active and passive management is the safest approach. You should do careful research to select a manager who is likely to outperform, but also to select one who takes risks that you find acceptable. By pursuing a diversified approach, you increase your chances of achieve positive results.