Active Versus Passive Management
Key Points – Active Versus Passive Management
- Defining Active Management and Passive Management
- The History of the Active vs Passive Management Debate
- The Cyclical Nature of Investing Disciplines
- 5 Minutes to Read
Defining Active vs Passive Management
Our Director of Investments Stephen Tuckwood, CFA has covered a wide range of topics with Dean Barber on The Guided Retirement Show. Toward the end of the episode, Strategic Investing Through Retirement, Tuck and Dean touched briefly on active vs passive management. We’re going to take a deeper dive into active vs passive management today to give you a better understanding of each investment strategy.
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Active Management
In its simplest form, active management is when a manager uses his or her perceived skill, research, intuition, experience, and analysis to pick a group of investments they believe will outperform a benchmark; usually, a market index of some kind. An active portfolio manager must pay attention to a lot of different things to accomplish their goal of outperformance.
They must monitor not only the health of the companies whose stock they own, but also market trends, economic shifts, and political conditions both here and abroad. As you might imagine, this usually requires a team of talented individuals in several disciplines.
This accounts for the generally higher fees associated with actively managed funds. Typically, active management is the domain of mutual fund managers.
Passive Management
Passive management is when a manager attempts to create a portfolio that mirrors a market index or benchmark. They select their holdings based on the companies listed on the index, in the same weighting, and hope to generate a return that is equal to the index they’re mirroring.
Since the goal of a passive management strategy is to replicate an index, there is no need for a large team of experts and is why pricing is far lower than active management strategies. Passive management is typically the domain of ETFs.
The History of the Active vs Passive Management Debate
The active vs passive management debate has been with us for a long time, going back almost to the issuance of the first active ETF in the U.S. in 1993.1 When they were first issued, ETFs were used almost exclusively by institutional investors to execute sophisticated trading strategies. However, it wasn’t long until financial advisors, and individual investors took to them as well.
Broad acceptance came slowly, though, as it took until 2003 for the ETF market to hit $200 billion.2 2007 was the peak year for ETF creation and saw the introduction of 270 ETFs.3 Then, on December 9, 2010, 17 years after the first ETF debuted, ETFs reached their first trillion dollars in assets.4 According to Schwab’s Q3 2010 Investor Snapshot, the ETF assets that Schwab custodied at that time were growing exponentially.5 Those ETF assets had grown 14% in the previous quarter, eclipsing $100 billion.
That $1 trillion in ETFs paled in comparison to the $11.5 trillion in mutual funds in October 2010, though.6 However, Nasdaq, Inc. shared that there were “incipient signs” that ETFs were stealing market share from mutual funds, such as Blackrock purchasing iShares7 and Guggenheim acquiring Claymore Group8. The active versus passive management battle was officially on.
Active Versus Passive Management: The Day they Became Equal
Now, let’s fast forward a little bit with the active vs passive management debate. In August 2019, passive assets under management (AUM) for U.S. equities grew to $4.27 trillion to overtake active AUM ($4.25 trillion) for the first time.9
Institutional Investor’s Julie Segal noted a few reasons why passive management had catch up to active management in the U.S. stock fund realm, namely that active managers were being challenged by the fee pressure of passive assets.10 She asserted that investors lost faith in the financial industry in general and in active managers’ abilities to protect them from deep market routs and that their “tastes seemed to permanently change.” You can’t blame her for thinking that to be the case.
Segal’s article contained a compelling infographic (see Figures 1 and 2 below). The switch from active to passive management over the 20 years from December 31, 1998, to April 30, 2019, was clear.
FIGURE 1 – Passive Goes Massive 1998 – Morningstar/Institutional Investor
FIGURE 2 – Passive Goes Massive 2019 – Morningstar/Institutional Investor
In 1998, 35.8% of assets in U.S. equity funds were in actively managed large growth mutual funds. By 2019, that number had dwindled to 17% while passively managed ETFs accounted for 33% of all the large-blend investment assets. But that’s just part of the story.
The Cyclical Nature of Active vs Passive Management
In Daniel Goldman’s article, Active Investing is Dead, Long Live Active Investing, from 2019, he notes the cyclical nature of investing disciplines and that active vs passive management is a debate that’ll likely last longer than most think possible.8
Goldman cited a white paper published by Hartford Funds that lays out how cyclical active and passive investing can be.9 One is never king for long. The Hartford Funds white paper, which was last updated in February 2023, active management outperformed passive management nine out of 10 times from 2000-2009. But that was preceded by passive outperforming active 1994-1998. Figure 3 also shows that passive outperformed active from 2014-2021.
FIGURE 3 – No Clear Winner in Active vs. Passive Large-Cap Funds – Morningstar and Hartford Funds
Where’s the Active vs Passive Management Debate at in 2024?
Now, let’s look at some compelling data from Morningstar from January 2024 to round out this active vs passive management debate.10 Figure 4, below, highlights how international equities and bonds have joined U.S. equities in the trend to passive management. So, as of the end of 2023, passive AUM for all asset classes totaled $13.29 trillion, while active AUM totaled $13.23 trillion.11
FIGURE 4 – Historical Fund Assets: Active vs. Passive – Morningstar
Encouraging Signs for Active Management
Simply from looking at Figure 4, passive management has all the momentum in the active vs passive management debate. But there may be some hope for active management if the Federal Reserve begins to cut interest rates later in 2024.12 With low unemployment, inflation slowing, and mortgage rates projected to decrease, there are already some encouraging signs for the economy, which could spur investors back to active management.
The Bottom Line with the Active vs Passive Management Debate
If there’s one thing to take away from the active vs passive management debate, it’s that active and passive investing are cyclical in natural. Active management has its place, and always will. Passive management has its place, and always will. True wisdom in the active vs passive management debate is realizing that and knowing when to apply either, or both, or neither.
We covered a lot of data with this active vs passive management debate. If you have any questions about what we’ve covered, start a conversation with our team below.
The active vs passive management debate is important, but there’s so much more to financial planning than your investments. A few factors that are more important than your rate of return include risk, taxes, inflation/interest rates/economic health, time, and a life plan with retirement goals. Think of your investments as the fuel that makes your financial plan run.
Each of those components, including investments, is critical to your personalized financial plan. That’s why we have a financial planning team, which is comprised of subject matter experts in each of those categories. Take Tuck, for example. He’s one of our CFAs that thoroughly assesses the active vs passive management debate and much more when it comes to investments. He shares that information with our CFP® Professionals and CPAs. Our team is committed to helping people gain more confidence that they’re doing the right things with their money, freedom from financial stress, and time to spend doing the things that they love.
Active Versus Passive Management | Watch Guide
00:00 – Introduction
00:50 – The Difference Between Active and Passive Management
02:31 – Passive Management & Fees
05:31 – Active Management and Risk
09:10 – ETFs and Mutual Funds
12:58 – Active vs. Passive in 2024
16:29 – From an Equity Perspective
22:00 – What We Learned Today
Resources Mentioned in This Article
- Strategic Investing Through Retirement with Stephen Tuckwood, CFA
- Proper Portfolio Construction with Stephen Tuckwood, CFA
- The Great Recession’s History Remains Relevant
- Can I Beat the Market?
- What Is Financial Planning?
- 5 Factors More Important Than Rate of Return
- 4 Retirement Risks That Are Out of Your Control
- Taxes on Retirement Income
- 10 Ways to Fight Inflation in Retirement
- The Effect of Rising Interest Rates on the Economy
- What Millionaires Do in Times of Economic Uncertainty
- Time Is Your Scarcest Resource in Retirement
- Nonfinancial Life Planning with Bruce Godke
- Why You Need a Financial Planning Team
- The CFP® Professional and CPA Relationship with Logan DeGraeve, CFP® and Corey Hulstein, CPA
- 7 Wealth Protection Tactics
- Financial Stress: How Do You Deal with It?
- Your Retirement Lifestyle: What Do You Want Your Retirement to Look Like?
Other Sources
[1] https://www.marketsmedia.com/the-story-of-the-first-us-etf/
[2] https://finance.yahoo.com/news/etf-beginners-guide-170339563.html
[3] https://www.planadviser.com/2007-a-year-of-records-for-etfs/
[4] https://www.businessinsider.com/december-etf-roundup-1-trillion-and-counting-2011-1
[5] https://www.etftrends.com/wp-content/uploads/2010/12/ETF-Investor-Snapshot-Q3-2010.pdf
[6] https://www.nasdaq.com/articles/us-etf-assets-hit-1-trillion-milestone-2010-12-15
[8] https://www.guggenheimpartners.com/firm/news/guggenheim-partners-to-acquire-claymore-group
[11] https://blog.politicoid.us/active-investing-is-dead-cea296e6a71e
[12] https://www.hartfordfunds.com/dam/en/docs/pub/whitepapers/WP287.pdf
[13] https://www.morningstar.com/funds/recovery-us-fund-flows-was-weak-2023
[15] https://money.com/active-investing-vs-passive-2024/
Investment advisory services offered through Modern Wealth Management, LLC, an SEC Registered Investment Adviser.
The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.