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Which is better for me: active or passive investing?

We believe that active and passive investing strategies are not mutually exclusive, and can actually be complementary

active or passive investment

Over the past decade, there has been a great deal of discussion and debate over whether investors should utilize active or passive investment strategies when allocating their assets and constructing their portfolios. While each strategy has its advantages and disadvantages, ultimately investors must consider their investment objectives, tolerance for risk, tax ramifications and the fees and costs attendant to each strategy. While this article will discuss the merits of each of these strategies, our conclusion is that active and passive approaches are not mutually exclusive and can be employed in a complementary manner. Importantly, investors must, as always, consider the risks involved in each strategy. And finally, investors should look at the sectors and geography they are considering, as active or passive may be more appropriate in differing market segments and market environments.

Active investing is the process whereby portfolio managers construct portfolios based on their research and investment skill. These managers consider macro-economics, various investment sectors, geography, security selection, risk and tax efficiency. By employing an active approach, managers and those who invest with them hope to achieve good, risk-adjusted investment returns. Active managers also have the opportunity to impose defensive strategies when markets are not performing well. Their strategies include avoiding struggling sectors or individual securities, hedging positions and increasing cash positions. Active managers proceed on the assumption that markets are inefficient, and therefore anomalies exist which may be exploited. They would argue that market prices do not properly reflect all of the data and information that should be factored in. Thus, they feel that they can use their knowledge and acumen to beat the market and manage risk.

Passive investing or indexing is a strategy whereby investors place their money in a portfolio that largely replicates an index such as the S&P 500. The manager who constructs the portfolio uses the same positions, usually in the same proportions, as the index they are trying to mimic. Passive strategies can be designed to replicate virtually all broad indices as well as more targeted sectors. The argument in favor of indexing is that many active managers do not outperform the index they benchmark to, and the operating costs and fees are much lower.

As mentioned above, we believe that these strategies are not mutually exclusive but can complement each other nicely in portfolio construction. The market capitalization area that challenges managers the most is the U.S. large-cap space. We believe that utilizing a passive strategy that mirrors the S&P can be a prudent approach to capture returns and save on costs. But in other, less efficient markets, and in many sectors, we believe solid due diligence can lead to the selection of superior managers who can potentially outperform their benchmarks over time.

We are also surprised that the active/passive debate rarely includes a discussion of risk, which is arguably the most critical investment criterion. Investing in an index guarantees that the investor will capture 100 percent of the market risk and therefore full downside participation. As stated above, skilled managers can use many tools to minimize risk. In closing, we believe that a wise advisor can combine active and passive strategies to gain the benefits of both options.

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Evan Steinberg and Todd Forman are private wealth advisors with the Wealth Management division of Morgan Stanley in New York, NY. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, member SIPC, Morgan Stanley Private Wealth Advisors engage Worth to feature this article. They may only transact business in states where they are registered or excluded or exempted from registration, Transacting business, follow-up and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where they are not registered or excluded or exempt from registration. The strategies and/or investments referenced may not be suitable for all investors.

The S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. An investment cannot be made directly in a market index.

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