What is Active Management?
Active management involves a portfolio manager making specific investments with the goal of outperforming an investment benchmark, such as the S&P 500 index. Active managers rely on their research, analysis, and judgment to select securities that they believe will offer superior returns. This approach typically involves higher fees, as you are paying for the manager's expertise.
What is Passive Management?
Passive management, also known as indexing, involves creating a portfolio that is designed to track the returns of a specific market index as closely as possible. The most common way to do this is by investing in an index fund or an ETF. Passive managers do not try to beat the market; they aim to be the market. This approach involves very little buying and selling, which results in lower fees and greater tax efficiency.
The Great Debate
The debate over which strategy is superior has been raging for decades. Proponents of active management argue that skilled managers can identify market inefficiencies and generate alpha (returns above the market benchmark). Proponents of passive management point to a large body of evidence showing that the vast majority of active managers fail to outperform their benchmark over the long term, especially after accounting for their higher fees.
Which is Right for You?
For most individual investors, a passive approach using low-cost index funds is the most sensible and effective strategy. It is simple, low-cost, and has a proven track record of success. While it may be possible to find a skilled active manager who can consistently outperform, the odds are stacked against you. As Warren Buffett has famously advised, most investors would be better off simply buying an S&P 500 index fund.
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