Active and passive portfolio management are two of the most common strategies that investors use in the financial markets. The primary goal of active portfolio management is to generate returns that are higher than what the benchmark index offers. Passive portfolio management, on the other hand, aims to merely replicate the returns of a benchmark market index.
Each of these strategies caters to different investor preferences, risk tolerances and investment goals. In this article, we are going to explore active and passive portfolio strategies, the differences between the two, and their various advantages and disadvantages.
What is active portfolio management?
Active portfolio management is a strategy that is often used by mutual fund managers. The strategy involves making calculated and well-researched investment decisions with the exclusive goal of outperforming the benchmark market index.
The strategy relies on extensive fundamental and technical research, forecasting market movements, identifying opportunities and strategic buying and selling of securities. Active portfolio management often involves frequent buying and selling of securities and constant monitoring of the markets, leading to higher costs.
Also read about: What is active management in investment
What is passive portfolio management?
Now, before we compare active vs. passive portfolio management, let us quickly look at the passive management strategy.
Passive portfolio management is a strategy that involves investing in the same set of securities as that of a benchmark market index in the same proportion and weightage. The primary goal of this strategy is to replicate the returns that the benchmark index provides rather than outperform it.
Once the portfolio is constructed, no further changes to it are made. The only time an adjustment is made is when there is a change in the composition, proportion or weight of the constituents in the benchmark index.
Since passive portfolio management neither involves frequent buying and selling of securities nor requires constant monitoring of market movements, trading and associated costs are minimised to a large extent.
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High-return mutual fund categories for smart investing
| Equity Mutual Funds | Hybrid Mutual Funds | Debt Mutual Funds |
| Tax Saving Mutual Funds | NFO Mutual Funds | Multi Cap Mutual Funds |
Key differences between active and passive portfolio management
To make an informed investment decision, you need to first understand the differences between active and passive portfolio management. Here is a table comparing the two approaches.
Particulars |
Active portfolio management |
Passive portfolio management |
Investment style |
A more hands-on approach that involves frequent trading of securities |
A buy-and-hold approach that involves little to no trading of securities |
Objective |
To generate returns that outperform the benchmark market index |
To generate returns that merely replicate that of the benchmark market index |
Research |
It involves extensive fundamental and technical research and analysis of securities across various aspects |
It involves very limited research since the approach merely tracks an existing market index |
Expenses |
Costs tend to be significantly higher due to frequent trading and active management of investment portfolios |
Costs are much lower compared to active portfolio management since there is very little management involved |
Flexibility |
The strategy is very flexible and can be adapted to different market conditions easily |
The strategy is often not flexible and follows a set pattern established by the market index it aims to replicate |
Risk |
Carries significantly higher risks due to active trading |
Carries much lower risk due to infrequent trading and better diversification |
Tax Efficiency |
It is not very tax-efficient since the strategy involves frequent purchases and sales of securities |
It is very tax-efficient due to lower portfolio turnover |
Consistency |
Consistency in performance and return generation varies depending on the fund manager’s skill, strategies employed and prevailing market conditions |
Performance and returns are often consistent with the prevailing market conditions |
Advantages of active portfolio management
Now that you have seen the differences between active and passive portfolio management, let us focus on the various advantages of the active portfolio management strategy.
- Potential for higher returns
Active portfolio management involves outperforming the benchmark index by capitalising on market inefficiencies and making strategic investment decisions. If successful, the approach can yield significantly higher returns compared to passive management strategies. - Tailored strategies
With active portfolio management, investors and fund managers can personalise their strategies according to their investment goals, risk profile and time horizon. Furthermore, the strategies can also be dynamically adjusted to be in line with changing market conditions. - Flexibility
Active portfolio management empowers fund managers and investors to react and respond quickly to even the most minor changes in market movements, economic events and new information. Such flexibility can potentially help mitigate losses and underperformance by capitalising on emerging opportunities. - Risk management
Active portfolio management also involves the use of carefully crafted risk management strategies such as diversification, hedging and stop-losses. Risk management can protect against potential losses and keep portfolio volatility in check. - Tax considerations
Although active portfolio management involves frequent purchases and sales of securities, fund managers and investors can use tax-loss harvesting strategies. These strategies allow them to offset gains with losses to reduce the impact of taxation.
Also read about: What is a Portfolio Management Service
Advantages of passive portfolio management
With the comparison between active vs. passive portfolio management and the advantages of active portfolio management out of the way, let us now look at the various benefits of passive management of investment portfolios.
- Low costs
One of the major advantages is the low expenses associated with this approach. The expense ratio of passive mutual fund schemes tends to be significantly lower than that of traditional funds due to their buy-and-hold approach and minimal trading activity. Such a high level of cost savings makes this approach an ideal option for cost-conscious investors. - Consistency
The returns offered by passively managed portfolios tend to be slightly more predictable and consistent since they only aim to replicate the performance of a benchmark market index. This reduces the uncertainty factor that is commonly associated with actively managed portfolios. - Tax efficiency
Owing to less frequent trading, passive portfolio management generates fewer taxable events. This often results in greater tax efficiency and potentially higher after-tax returns for investors. For example, passive portfolios eliminate short-term capital gains (STCG) tax entirely due to their buy-and-hold approach. - Diversification
Since passive portfolio management involves replicating a market index, which usually consists of a broad range of securities across sectors, market capitalisations and types, investors get the benefit of enhanced diversification. Such a level of diversification significantly reduces the impact of individual security risks on the overall portfolio. - Accessibility
Passive portfolio investing is straightforward and accessible to a wide range of investors, irrespective of their knowledge or experience in the financial markets. This ease of access makes the approach an attractive option for investors looking for simplicity.
Also read about: Advantages of Exchange Traded Funds
Disadvantages of active portfolio management
Although understanding the advantages of active and passive portfolio management is crucial, being aware of their drawbacks is also equally crucial. Here are some of the disadvantages of active portfolio management.
- Higher costs
Active portfolio management entails higher management fees and transaction costs due to frequent trading, constant monitoring of the markets and extensive research and analysis. The higher costs could potentially decrease profits or widen losses. - Unpredictable performance
The performance of the investment portfolio can be inconsistent and dependent on a wide range of factors, such as the fund manager’s skill and experience, trading strategies and prevailing market conditions. - Higher risks
The risks associated with active portfolio management tend to be much higher owing to improper stock selection and the wrong timing of investments.
Disadvantages of passive portfolio management
Passive portfolio management also has its fair share of disadvantages. Here is a quick overview of some of the key drawbacks of this approach.
- Limited flexibility
Passive portfolio management lacks the flexibility required to effectively navigate or adapt to changing market conditions or economic shifts. - Exposed to market downturns
Since the passive approach entails holding onto investments regardless of market conditions, investors are fully exposed to market downturns, which could potentially lead to a significant drop in the value of their securities. - Lower returns
The goal of passive portfolio management is to match the returns offered by the benchmark market index and not exceed them. This approach may not be suitable for investors seeking high returns from their investments.
Also read about: What are equity funds
Factors to consider when choosing between passive and active management
Choosing between an active and passive portfolio strategy requires careful consideration of the following key factors.
- Investment goals
The investment approach you need to opt for depends primarily on your investment objectives. Therefore, you need to first determine whether your primary objective is to match market performance in a cost-efficient manner or achieve higher returns, even if it means taking on increased risk and expenses. - Risk tolerance
Your risk tolerance level dictates how comfortable you are with market volatility and the potential for losses. Active management often requires you to have a high tolerance for risk. Passive management, on the other hand, may be ideal if you have an aversion to risk. - Time and involvement
The amount of time and effort you are willing to set aside is another key factor to consider when choosing between an active and passive portfolio strategy. Active management requires a more hands-on approach, whereas passive management requires very minimal involvement. - Market conditions
The current market conditions may also influence the kind of approach you need to take. An active strategy can help you better navigate market fluctuations during periods of heightened volatility and downturns. A passive strategy, meanwhile, can be more beneficial during stable and upward-trending market conditions.
Which is better between active vs. passive portfolio management?
There is no definitive answer to which of the two investment approaches is the better option. In fact, it is heavily dependent on factors such as individual circumstances and preferences. Active portfolio management offers higher returns but at the cost of increased expenses and risks.
Passive management, on the other hand, maybe more cost-effective and simple but will most likely not produce returns that outperform the market. That being said, as an investor, you could consider employing strategies that combine both active and passive portfolio management approaches. This way, you can benefit from both of these methods.
Conclusion
It is clear from the comparison between active vs. passive portfolio management that both of these approaches are distinct from one another, each with its own set of advantages and drawbacks. The choice between them ultimately depends on factors like your investment goals, risk tolerance, time commitment and market conditions.
If you are interested in investing in mutual funds, the Bajaj Finserv Mutual Fund Platform can help. You can find more than 1,000 different funds, including those that employ active and passive portfolio management strategies. Furthermore, the platform also lets you compare mutual funds across different key metrics and use a mutual fund calculator to estimate the returns you are likely to receive from your investments.
