How do active and passive fund management differ?

I just started learning about investing, and some of the terminology is a little confusing. What is the difference between passive and active investing, and which one is best?

When looking at mutual funds as a component of an overall investment plan, many criteria distinguish one fund from another. These criteria include asset class (stocks, bonds, international, and industry sectors), load or no-load (sales charges and/or commissions), and management style. From the standpoint of management style, mutual funds are generally categorized as being either actively or passively managed.

Passive management, a category that includes index investing, is an investment strategy that attempts to replicate the returns of an index or benchmark by owning the same assets, in the same proportions, as the underlying index. For example, a passively managed large cap index fund that seeks to replicate the Standard and Poor’s 500 Index (S&P 500) would own all 500 stocks that comprise the S&P 500 Index.

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Passive management focuses on the assumption that markets are perfectly efficient and stocks always trade at their fair value price. This means no one stock is ever over- or undervalued. This is the primary difference between active and passive investing. Active investors believe that markets are not always perfectly efficient, and there are over- and undervalued stocks that provide different investment opportunities.

Investors utilize passive management because it provides broad market diversification and low relative internal expense ratios. Since passive portfolios do not require managers to expend significant resources researching the market or selecting stocks, passive management tends to be less costly than active management. In addition, since passively managed investments track a market index, those mutual funds benefit from a relatively low portfolio turnover rate. Fewer trades translate into lower transaction costs.

Passive management is essentially a buy-and-hold strategy that results in relatively low trading costs despite the large number of security positions within an index portfolio. Passive investing through an index fund also provides significant diversification benefits since index portfolios hold all the stocks comprising their specific asset class.

Next: Active management

In contrast to the passive buy-and-hold approach, active fund managers attempt to outperform the market through the art of stock picking and market timing. For example, the active large cap manager would try to pick a limited number of the best (in their opinion) stocks, be it 50 holdings or a couple hundred of those S&P 500 holdings, for inclusion in their mutual fund. Investors choose these actively managed stock market funds that utilize various stock selection strategies in order to potentially gain higher rates of return in relation to the market indices.

While it’s human nature to want to perform “better than average,” beating the average in the investment world is extremely difficult, especially on a consistent basis. Successful active investing requires that managers identify market inefficiencies, and that investors or their financial advisers identify the managers who do this on a regular basis. Successful active managers generally feel that as the market retreats, the actively managed funds will be in a better position to minimize losses through the selling of various holdings and moving either to cash or buying quality companies at discounted prices, thus enhancing the funds’ long-term performance results. But to support necessary research and trading infrastructure, actively managed funds spend more money in overhead and staffing-costs that may be reflected in the higher fees charged by active managers, thus making it even more difficult to beat the market averages.

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Academics and investment experts continue to debate the merits of active and passive investment management, and no clear consensus has been reached on whether one approach is superior to the other. Therefore, it’s important to base your decision on a careful analysis of your investment goals and risk tolerance.

I used to practice medicine as an independent contractor and set up my own simplified employee pension individual retirement account (SEP IRA). I just joined a practice that offers a 401(k) plan. Can I roll my old SEP IRA into my new 401(k)?

The simple answer is yes! You can roll an old SEP IRA into a 401(k). As long as you follow the procedures, IRS rules should let you make the move without too much hassle. The only complication comes if you have a 401(k) that includes a designated Roth account. These Roth 401(k) options allow you to save money on an after-tax basis. But because SEP IRA money is always pretax, you can't roll over Roth 401(k) money into a SEP IRA, and rollovers from the SEP to a designated Roth account are also prohibited.

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Send your questions about estate planning, retirement, and investing to Jeff Witz, CFP, c/o Urology Times, at UT@advanstar.com Questions of general interest will be chosen for publication. The information in this column is designed to be authoritative. The publisher is not engaged in rendering legal, investment, or tax advice.

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