11 Jul What Is Your Risk Profile?
Unsure about how best to invest your retirement savings? Here’s the rundown on passive vs. active investing.
By Alexandra Kay
When Jackie Cummings Koski of Dayton, Ohio, finalized her divorce in 2004, she ended up with $60,000 in a 401(k). She moved it to an IRA to invest the money on her own. She had been burned dabbling in stocks in the late 1990s, so she was determined to make sure that wouldn’t happen again. Cummings Koski joined an investment club and learned how to research companies and put together a portfolio of stocks. Although she could invest only $100 a month with the investment club, there was no rule that she couldn’t invest more on her own. As her own asset manager for that one active account and with other passive accounts through her job, Cummings Koski was able to save enough to retire at 49. She admits that over time she has changed her investing approach to incorporate more passive investments, and now her assets are balanced between active and passive accounts. “Even though I’ve done well with some active investing, I’m not willing to say I’ll go active on all my accounts. There has to be balance, and research has shown that most passive investments do better over time,” says the 52-year-old, who has a master’s degree in personal financial planning and financial therapy.
So what’s the difference?
Active investing is when a fund manager strategically tries to do better in their fund or strategy than its relative peer group. “There is active oversight and trading of a particular strategy,” says Cathy Pareto, MBA, CFP, of Cathy Pareto and Associates in Coral Gables, Florida. Because fund managers do research, assess the investments in a fund’s portfolio, and take into account economic factors in order to use the information to buy and sell, it costs more to invest in actively managed funds. Fees for an actively managed fund average between 0.5 percent and 1 percent, though some are higher.
Active investing can have advantages for some investors and in certain situations. Wealthy investors may have enough money to seek out the best advisers, those who have beaten the market on a regular basis. Additionally, “the active strategies probably are better suited for asset classes or parts of the market that are less liquid or perhaps need more oversight,” says Pareto. These could be areas with interest-rate risk or geopolitical risk. Active investing can also offer flexibility in trading, allowing investors to manage risk by offering the ability to leave certain investments. It can provide some tax-management benefits as well. Investors can offset gains in some investments by selling others that have experienced losses.
In passive investing, an investor buys into a predetermined basket of assets with the intention of holding those investments for a long period of time. The investor chooses a fund such as an S&P 500 large cap fund and leaves the investment alone. “It’s set it and forget it,” says Pareto. “There’s no active oversight or active attempts to do better than the market.” A passive investment seeks to mirror the market returns over the long term rather than to beat it. Because of this, fees for passive funds tend to be significantly lower than those for actively managed ones, averaging about 0.2 percent. “The fund manager isn’t doing as much, so it doesn’t cost as much,” says Diana Avery, CFP, retirement planner and wealth adviser with Avery Financial Services in Atlanta, Georgia.
Passive investing has several advantages in addition to low fees. It’s tax-efficient because the buy-and-hold strategy doesn’t incur capital gains tax from sales. And there are no surprises in a passive fund. Investors are provided a list of assets indexed in the fund.
Both kinds of investing can have disadvantages as well. In addition to the higher expense fees, actively managed funds can have increased risk because of the potential for an investment to negatively affect portfolio performance. The only potential disadvantage of passive investing is an inability to leave the market if it crashes. But because passive investing is meant for the long term, this is an issue only if someone is close to retirement and hasn’t switched to a more conservative investment strategy given the reduced time frame. Investors with years to go until retirement have time to recover from a severe downturn.
Which style is right for you?
Overall, if you have time on your side and you like a hands-off approach, passive investing is probably for you. It should also be your choice if you don’t want to pay the higher fees associated with active investing or you don’t have a large amount of money to invest, because many active fund managers require a large upfront investment. Passive investing offers lower-cost investing, and over time, passive funds outperform active funds the majority of the time. In fact, according to the June 2021 S&P Indices Versus Active (SPIVA) Scorecard, research that measures actively managed funds against their relevant index benchmarks worldwide, 95.65 percent of actively managed large-cap funds underperformed the S&P 500 over a 20-year period ending in 2021. The numbers are similar for most other actively managed firms (though some do a bit better, and a small percentage outperform passive counterparts).
If you’re investing through a retirement account at work, you’re likely already investing in passive funds—and doing fairly well at it. The S&P 500 averaged 7.45 percent (5.3 percent when adjusted for inflation) between 2001 and 2020. Over 30 years, the average was over 10 percent. “Passive investing is one of the few ways that you can be average and be summa cum laude in investing,” says Rick Kahler of Kahler Financial Group, a fee-only financial planning firm in Rapid City, South Dakota. Kahler notes that in the beginning, he was a proponent of active investing, but that time and research have convinced him passive investing is the “best game in town.”
Both Caputo and Avery believe there is a place for both strategies in investors’ portfolios, though. “It depends on goals, objectives, and risk tolerance,” says Avery. “A person with 30 or 40 years in the market may get involved with a passive strategy and do very well because they have a lot of time. An active strategy may work for someone with a shorter time frame and more risk tolerance.” Caputo notes an active strategy could work better with international or alternative investments, while a passive strategy is likely better for large US corporations.
How to find a good financial planner
If you’re already investing through your job and your only goal is retirement, you may not need to hire a financial planner. But if you have other financial goals—say, planning, budgeting, and saving for heirs—then you could benefit from hiring someone who could work in collaboration with other advisers, such as your CPA or attorney.
“Look for someone who is not commission based and has no incentive to peddle products,” advises Pareto. You want an adviser who is compensated by you in a transparent fashion and therefore has your best interests at heart. Then look for credentials, says Avery. You want a planner who’s board certified. The best-known certification is the Certified Financial Planner Board of Standards (CFP designation). This means your planner is held to fiduciary standards and to ongoing continuing education requirements. Finally, you want someone with experience who has a clean regulatory record. The CFP Board website (cfp.net) has a place to search for advisers and check their regulatory record, notes Pareto. NAPFA.org and Garrett Planning Network (Garrettplanningnetwork.com) also have CFP search options.
Before making your choice, weigh your options carefully. Both Avery and Pareto believe the choice should be made on an individual basis. Says Avery, “Sometimes you have to look at the goals and objectives and make the right decision for you.” DW
Alexandra Kay is a full-time associate professor of English and part-time freelance writer who lives in Cold Spring, New York, with her young son.
If you’re investing through a retirement account at work, you’re likely already investing in passive funds—and doing fairly well at it.