Passive investing has been steadily growing in popularity thanks to the proliferation of low-cost index funds and exchange-traded funds (ETFs). Investors who opted for this hands-off approach were rewarded over the course of the most recent bull market, which spanned 2009 to 2020 and resumed after the initial COVID-19 lockdowns.
One asset management firm, though, says now is the right time to reconsider your set-it-and-forget-it approach and turn to active investing. Citing rampant inflation and higher interest rates, AllianceBernstein says equity investors should reconsider active investment portfolios.
“While passive funds are generally cheaper and have a role to play in allocations, active portfolios offer benefits that are worth paying up for – especially in times of dramatic change,” a trio of senior investment analysts wrote for AllianceBernstein.
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Active vs. Passive Management
An investment fund isn’t solely defined by the assets that comprise it. The management strategy that a fund employs can be just as critical to its success. Active and passive investment strategies are two fundamentally different and widely contested approaches to portfolio management.
- Active management. Actively managed funds seek to outperform a specific benchmark or the market as a whole. Active strategies typically involve a higher volume of trades in an attempt to generate alpha – a measure of how much an investment outperforms a benchmark over a specific timeframe.
- Passive management. While actively managed funds still hold a larger percentage of total assets compared to passive funds, that may eventually change. Passive funds, which accounted for approximately 25% of total assets in 2013, held just under 50% by November 2022, according to Morningstar. Passive funds also have a higher net inflow of assets compared to active funds – a trend that has remained consistent for the last 10 calendar years.
And passive strategies have largely outperformed active portfolios over the last 15 years, according to the S&P Indices Versus Active (SPIVA), a semiannual scorecard that tracks the performance of actively managed funds against index benchmarks. For example, the S&P 500 has outperformed more than 89% of all domestic large-cap funds over the last decade and a half. The S&P SmallCap 600, meanwhile, has outperformed 92% of all domestic small-cap funds during the same period.
Passively managed funds also cost less than their active counterparts. The average expense ratio of an actively traded equity mutual fund was 0.68% in 2021, according to the Investment Company Institute. Meanwhile, the average expense ratios of equity index funds and equity ETFs were just 0.06 and 0.16%, respectively.
Why You Should Reconsider Active Management
Despite the many ways in which passive management may be preferable, AllianceBernstein says changing market conditions will require investors to integrate a more active approach.
Here are several emergent reasons why you should reconsider active management, according to AllianceBernstein:
Inflation and possible recession. Inflation and interest rate hikes have the economy heading for a potential recession. The AllianceBernstein analysts say the current economic environment will require a more discerning investment approach. Finding strong companies with earnings growth and performance that outpaces inflation will be critical for investors.
“Long gone are the days of virtually free financing and the ‘growth at any price’ mindset,” the AllianceBernstein analysts wrote. “Instead, a higher cost of capital will necessitate corporate discipline, as well as an active approach to identify those companies with pricing power, earnings and profit margin sustainability, lower debt and company-specific business momentum.”
Changing sector and style trends. The asset management firm says the days of outperformance by “mega-cap” technology companies are also over – at least for now. In their wake, AllianceBernstein believes a wider variety of companies will drive returns, which favors active managers tasked with identifying those businesses.
“Active managers can incorporate fundamental research on individual businesses with forward-looking perspectives on sector and style exposure that backward-looking benchmarks cannot,” the firm wrote. “As mega-cap and hyper growth tech stocks fell back to earth last year, the market broadened.”
Active managers can be more selective internationally. AllianceBernstein also notes that active managers may be better positioned to capitalize on new opportunities in emerging markets. While U.S. equities have outperformed non-U.S. stocks in eight of the last 10 years, according to the firm, emerging market equities have shown recent signs of life. But macroeconomic conditions and a “company’s regional revenue exposure” may vary from country to country, underscoring the value of having a pliable, active approach to non-U.S. investments, AllianceBernstein says.
“Passive portfolios can’t lean into countries that have underperformed but may offer strong recovery potential,” the AllianceBernstein analysts wrote. “Active managers of global portfolios can tilt allocations to companies around the world that are attractively priced and likely to benefit from exposure to positive macroeconomic and business trends.”
Bottom Line
Index funds and ETFs offer low-cost, hands-free ways to invest in the stock market. While passively managed funds appear poised to eventually surpass actively managed funds in total assets, AllianceBernstein says investors shouldn’t turn away from active management. Economic challenges and changing market conditions mean the days of hyper growth are over. Instead, the ability to identify strong companies, sectors and markets is now more important than before.
Investing Tips
- You don’t have to go it alone. A financial advisor can help you build a portfolio of investments designed with your financial goals in mind. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Estimating your tax liability is a vital part of managing your investment portfolio. SmartAsset has a tool specifically designed to help you calculate your capital gains tax bill, which may make tax-loss harvesting that much easier.
Artic;e by Patrick Villanova, CEPF®, Smart Asset.
