One of the most debated topics for investors is whether it is worth it to invest in active funds. There are certainly advantages and disadvantages, and it is understandable why active managers often get a bad reputation. Historically active fund managers have underperformed the broader index, which is one of the reasons that explain the skepticism of passive investors.
This trend has been observed since the start of the century, with the increased inflow into passively managed funds.
This underperformance has been the key driver of inflows to passive funds, which now control pretty much the same amount of assets as actively managed funds.
The inflow of funds into passive investment vehicles has created what some call a passive investing bubble. We are witnessing the decline of active portfolio management, we should ask ourselves if active portfolio management is still worth it? Should you pay higher fees to underperform the broader market or should you invest in an index fund?
To answer this question we need to take a deep dive into the advantages and disadvantages of active portfolio management.
Advantages of active portfolio management
There is one major reason why active funds still get inflows - to beat the market. The only reason why investors consider actively managed portfolios is the possibility of beating the market, and that alone is attractive enough to pay a higher. The reality is that most active managers do not outperform the market over the long run. This leads to other advantages of actively managed funds, especially when we compare them with their passive counterparts.
Some of those advantages include:
- Active portfolio management is more efficient
- It allows investors to take profits
- It allows investors to hedge their portfolio
- Possibly outperforming the market
- You can buy stocks that are not even owned by most funds
- The best option to get exposure to a certain location or sector
One of the greatest strengths of active portfolio management is the ability to be extremely efficient when done right. Passive funds are forced to buy every stock in the index, and this can be an inefficient way of allocating capital. Being able to pick individual stocks, and manage the portfolio based on recent performance allows investors to be a lot more efficient with their portfolios.
Additionally, the decision to add or remove stocks or assets from the portfolio is done based on research. With index funds, you are limited not only to the stocks on the index but also to their weight on the index.
Active portfolio management also allows investors to trim positions and take short-term profits that would otherwise be impossible to do with index funds. This is certainly one of the most attractive advantages of active portfolio management.
The ability to hedge your own portfolio is also one of the reasons why active portfolio management is so relevant today. There are clearly ways of hedging an index fund, or a passive portfolio, but since it is made up of so many assets it is harder to do it efficiently.
Beating the market
The possibility of having above-average returns still remains the main active portfolio advantage, and the reason why investors choose it over passive. Investors searching for higher returns are bound to take a shot at active portfolio management, and this still remains the biggest advantage of active investing.
Some stocks are not in any fund, and the reason is that institutional investors do not cover some small caps. It is understandable why, since there is not a lot of information on these companies, and they also tend to be risky.
There are, however, a lot of high-quality small caps that allow you to get above-average returns. A passive investing strategy will disregard most of these stocks, although some of them are worthy of researching and investing.
The reality is that most funds tend to ignore small caps and deem them as unworthy stocks. This is where some of the free alpha in the markets is. When nobody is looking or paying attention, there are several bargains to be had at great prices.
Active portfolios are still the best way to get exposure to some geographies or sectors. Whether you are doing it on your own, or you invest in an actively managed fund, this is still the best approach. If you want to research each sector, or country individually, an active portfolio is the best solution. You may also look for actively managed funds in that niche if you do not have that much knowledge of it.
Disadvantages of active portfolio management
Although there are clear advantages of an actively managed portfolio, there are also disadvantages such as:
- Higher costs
- It requires research
- Lacks diversification
- Unsuitable for most retail investors
- It can lead to overtrading and market timing
- Lower expected returns
- Higher risk
Whether you are actively managing your own individual portfolio or you are invested in an actively managed fund, your costs are expected to be higher. Broker fees to transact each stock will be higher, or if you are invested in a fund, their fees also tend to be a lot higher than index funds. These higher fees might even impact your overall returns, and it may be better to take a passive investing option.
An active investment strategy requires research, and it takes not only time but also dedication. If you are individually managing your portfolio, you need to research each stock, while managing and constructing the portfolio. Even if you are investing in an actively managed fund, you have to make sure you check the fund’s portfolio, and what they are buying and selling.
Whatever way you wish to approach this, it requires time, and time is money. The amount of time you will invest into an active investment approach might not be the best return on time invested.
Lack of diversification
Diversification varies from portfolio to portfolio, and although there is a strong case to be made in favor of concentrated portfolios, the reality is that some active portfolios lack diversification. This may not be an important factor for seasoned investors, but for most retail investors that are risk-averse and unaware of the risks, it might not be the best solution.
For most retail investors that are not willing to put in the time, or have the knowledge to manage their portfolios efficiently, active portfolio management makes no sense. They are better off investing in a passive index fund, that still allows them to earn a decent return, without the risks and disadvantages of active portfolios.
Overtrading and market timing
Another disadvantage of active portfolio strategies is that they can lead to overtrading and excessive market timing. If you are trying to manage your own active portfolio, this is clearly one of the disadvantages you will encounter. Not only are you more likely to make emotional decisions, but also to try to time the market, which ends up costing you money in fees, and potentially underperforming.
Lastly and certainly the most significant disadvantage of actively managed portfolios is that they are far riskier than their passive counterparts. The reason is that they are not as diversified, and in search of above-average returns, you are likely to pick some bad apples.
Even if you are invested in an actively managed fund, the fund manager is bound to pick some stocks that will underperform. Therefore, actively managed portfolios are not appropriate for risk-averse investors.
Active vs passive portfolios have been one of the most heated debates in finance for decades, and it will continue to be at the center stage. Overall investors that are willing to put in the time and effort required to actively manage a portfolio or invest in actively managed funds should do it. If you are not willing to dedicate that amount of time, or you are not even inclined to do so, the best approach is to buy a low-cost index fund.