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Does Active Management Have a Place in the Modern Investment Portfolio?

As index funds have become more and more popular a rising question has been, does active management still make sense for the average investor? Answer is of course not simple enough for a yes or no answer. However there are a few pros and cons we can look at for the two options. First let’s look at the advantages of passive management:

1) Relative autonomy 

Time is often saved from having passive investments. While of course there is initial research that goes into selecting the underlying ETF’s or mutual funds, once set up your strategy you will have relatively low time costs going forward.

2) Lower expenses

With passive management comes low expenses. Over the long term expenses can eat into  a large portion of your returns so paying close attention to this is crucial.

3) Lower taxes

Active management usually means less trading and less trading means both less transaction costs and less capital gains tax. Both of these add up in the long term.

Now that we’ve covered a few of the pros of passive management let’s dive into some of the pros of the alternative…

1) Potential for greater returns

By definition a passive manager can’t meaningfully beat their respective benchmark. However with active management everything changes. There is also ways a chance for outperformance. Of course the flip side of this double-edged sword is that you can underperform, which is often the case.

2) Lower volatility

Depending on the management style you are able to experience lower volatility in your investments from active management.

So which should you choose? After everything is said and done the thing that matters the most is your returns relative to the corresponding benchmark index. For example if you’re comparing a large-cap active fund verses and S&P 500 index fund.

Once you’ve selected your funds for comparison you need to determine if a) your fund has outperformed the benchmark in the past enough to cover expenses and additional active costs and b) will the fund continue to perform this way or better in the future.

If you can answer yes for both of these questions you may have a great candidate for an active portion of your portfolio.

The last option you have available is to execute the active management your self. This is a whole different story that deserves it’s own separate discussion for a different post. For the time being focus on comparing returns both pasts and potential for the future.