We're going to look at some of the key differences between active and passive Investment Management to understand some of the key differences between these two approaches to investing.
The first difference to note is in terms of the aim of the fund.
A passively managed fund aims to generate the same return as a benchmark or an index which could be achieved through holding a portfolio of the same Securities in the same weights as the benchmark.
In contrast and actively managed fund is trying to generate better returns than the Benchmark also referred to as generating Alpha.
A good active fund is not simply one which generates good absolute returns, but one which generates more return than could have been achieved through an equivalent passive fund active funds tend to be analyzed and assessed on this relative returns basis.
Part of the logic behind investing in passive funds is that the investor believes that Securities are fairly priced meaning that there is little point in hiring a fund manager to try and find misprice Securities since they don't exist to any great extent.
However, actively managed funds are trying to beat The Benchmark and to do so they must believe they can find undervalued Securities in which to invest more money and overvalued securities in which to invest Less in order to beat the benchmark.
Passive funds tend to be transparent as to which Securities they hold since they will be very similar to The Benchmark. However, active managers do not reveal their portfolios on an ongoing basis since this would reveal the strategy they are using in their attempts to beat the benchmark.
Next passive funds tend to engage in fewer transactions to buy and sell Securities and as such tend to have lower trading costs than actively manage funds as well as having lower management fees since there is no fund manager making decisions as to which Securities to invest in.
The fee level is the main determining factor between different passive funds since generating. The return of the Benchmark is taken as a given.
For an investor the lower the fees the better the passer fund.
For active funds there are higher trading costs through more frequent trading to enact the manager's decisions and also higher management fees to cover the costs of the work done by the portfolio manager in their attempts to find missed price Securities to help them to outperform the benchmark.
When considering the outperformance of an active fund Against The Benchmark, it is vital to consider this after management fees since these will not be the same in both active and passive funds.
Passive funds will be highly correlated with their respective Market since their aim is the generate the same return as the market while the Returns on active funds will deviate from The Benchmark in their attempts to beat it creating more dispersion of returns and therefore lower correlation with the market itself.
Passive funds are also less reliant on management judgment since they attempt to passively follow the Benchmark, although there is some decision making required when benchmarks are rebalanced or reconstituted an active funds ability to outperform a benchmark is highly driven by the skill and Judgment of the portfolio manager.
An example of a passively managed fund would be an S&P 500 ETF which is attempting to generate the same return as the S&P 500 and a hedge fund would be a good example of an actively managed fund. It's trying to generate as much return as possible given its particular strategy.
