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Active or Passive Management... Why Choose?

February 29, 2016

Active and passive management styles may both have a place in your portfolio because they can complement each other's strengths and weaknesses.


 

Why pick apple pie or ice cream when you can have apple pie and ice cream? Sometimes, you don’t have to choose. Each has their individual advantages and drawbacks, but when combined, they can complement each other to build a better dessert. The same can be said about investment-management styles and building your portfolio.

There are two types of management styles: active and passive. Like all investments, each comes with certain risks. Passively managed funds seek to mirror an index, using the same securities and the same weightings (or by using a representative sample of securities from the index). By contrast, the portfolio managers of actively managed funds use research to handpick stocks they think will help the fund meet its objective.

 

Which Style Performs Better?

 

It can be difficult to see the benefits to both styles because passively managed exchange-traded funds (ETFs) and mutual funds have performed well and increased in popularity in recent years. If it’s not broken, why fix it?

Here’s why: Investing can be likened to running a marathon, not a sprint. So while recent performance is fresh in our minds, it’s important to keep a long-term horizon in mind. And over that longer timeframe, neither management style is an outright winner because they have tended to outperform in cycles.

Although past performance is never a guarantee of future results, passive management has performed well during the most recent bull market, which began in March 2009 and continued for more than six years. Since passive funds seek to mirror indices, much of that performance was likely because passive management has tended to outperform when stocks are generally rising in lockstep.

 

What Happens When the Markets Shift?

 

But in January 2016, both the S&P 500 Index1 and the Dow Jones Industrial Average2 dipped 10% from their May 2015 highs, putting them into correction territory. Unlike passive funds, active funds have historically tended to outperform during market corrections, likely because it is easier to handpick stocks when they’re not broadly rising en masse.

There have been 21 market corrections since 1987. During those corrections, active managers outperformed passive strategies 76% of the time (16 out of 21).

Actively managed funds also have tended to outperform during periods of rising rates; in the last three decades, active funds outperformed passive funds 82% of the time when rates were rising. This is important to note because in December 2015, the U.S. Federal Reserve announced its first rate hike since 2006, and is generally expected to continue raising interest rates at a gradual pace throughout 2016.

In addition, diversification is an important component of building a sound portfolio. Including both types of management styles is one way to add layers of diversity. But actively managed funds can provide an additional layer with their ability to differ from their benchmark, which can address some of the concentration problems inherent with passive investing.

When Rates Rise, Active Management Has Tended To Outperform

CC_feb2016_fig1

Active Large Blend Outperformance Compared to Passive Large Blend (Periods of Rising Rates Over Last 30 Years). “Active Large Blend” is made up of funds from the Morningstar Large Blend category that are not index or enhanced index funds. “Passive Large Blend” is represented by the Morningstar S&P 500 Tracking Category. Source: Morningstar, 1/16.

 

For example, benchmarks for both fixed income and equities tend to have unintentional biases. Because some companies within an index are so large, equities tend to get a heavier weighting based on their size and not necessarily their fundamentals. And in fixed income, world benchmark indices are forced to weigh heavily toward nations with the most debt, not necessarily the strongest borrowers.

 

You May Not Have to Choose

 

The final argument for building a balanced portfolio is that we can be our own worst enemies. Passive vehicles such as ETFs provide the option to buy and sell throughout the day, like stocks. However, this convenience can actually be detrimental to your returns in the long run. Once again, investing is a long-term endeavor, and not putting all your nest eggs in the same temptation-ridden basket can help you avoid harmful short-term behaviors.

Like many things in life, deciding which management style best fits your personal preferences and risk tolerance takes careful consideration. Schedule time with your financial advisor to discuss whether active, passive, or a combination of the two makes the most sense to help you reach your individual goals.

 


 

1 S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.
2 Dow Jones Industrial Average is an unmanaged, price-weighted index of 30 of the largest, most widely held stocks traded on the NYSE.

All investments are subject to risk, including the possible loss of principal.

This information should not be considered investment advice or a recommendation to buy/sell any security. In addition, it does not take into account the specific investment objectives, tax and financial condition of any specific person. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. This material and/or its contents are current at the time of writing and are subject to change without notice. This material may not be copied, photocopied or duplicated in any form or distributed in whole or in part, for any purpose, without the express written consent of Hartford Funds.

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