Active or Passive Strategies: How to Choose?

It's one of the most important—maybe even the most important question—in the fund world. It is possible for investors to reach their financial goals using either approach, or by blending the two.

Active and Passive Strategies

It's one of the most important—maybe even the most important question—in the fund world. It is possible for investors to reach their financial goals using either approach, or by blending the two. Using an all-index portfolio is generally a low-cost, low-maintenance way to go. On the other hand, investors can also buy and hold active funds; the key is doing their homework and having the discipline to stick with their active managers through the inevitable rough patches.

Here is a quick review of some of the key attributes investors often seek, as well as how index and active funds deliver on each.

Low Expenses

Although not all index funds and ETFs have low costs, and not all active products are pricey, expenses on passively managed products are generally lower than the expenses of active funds. That expense advantage is a big reason that broad-market index funds have delivered solid returns versus market benchmarks over long periods of time in the past.

Simplicity/Ease of Use

Looking to build a minimalist, low-maintenance portfolio? It's simple to do so by arriving at a target asset-allocation mix, then populating it with just a handful of broad-market-tracking index funds or ETFs. In contrast, by mixing and matching actively managed funds, investors may end up with overlap, and it can be difficult to maintain tight control over the portfolio's asset allocation. Index-fund investors also don't have to worry about operational issues such as manager departures.

Tax Efficiency

Although index funds and ETFs aren't universally tax-efficient (bond index-fund investors may owe taxes on their income just as active bond-fund owners would, and some ETFs have socked their investors with big tax bills), broad stock market-tracking vehicles have tended to be pretty tax-efficient over time. Because active fund managers might trade more often, there's a greater likelihood that an active fund will pass taxable capital gains on to its shareholders.

Ability to Outperform the Market

Index funds have, on average, delivered fine returns for their shareholders, with the majority topping their category peers', sometimes by wide margins, over short and long time frames. That's a huge selling point. But investors hung up on "beating the market” may not get there with index funds. If an index fund is properly tracking its benchmark, the return will be the benchmark's return, minus expenses. Active funds, by contrast, offer at least the prospect of beating the market.

Ability to Adjust to Changing Market Conditions

One of the key potential benefits of an active approach is that a manager usually has the latitude to make changes based on market conditions. For example, he might decide to hold cash because stocks look expensive and he can't find things to buy, thereby helping to protect investors if stocks sell off. Alternatively, a manager could take advantage of weak markets to load up on beaten-down securities that short-term investors have discarded. If an index-fund investor wishes to be opportunistic, meanwhile, she'll have to do it herself.

Investors should bear a few caveats in mind before embracing an active fund for its flexibility and opportunism, however. Many active managers might not be all that active, and different managers have different skill levels in selecting investments. Finally, it's worth noting that index-fund investors can easily add an element of active management by periodically rebalancing their portfolios.

Mutual funds are sold by prospectus, which can be obtained from your financial professional or the company and which contains complete information, including investment objectives, risks, charges and expenses. Investors should be read the prospectus and consider this information carefully before investing or sending money.

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