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Active vs. Passive investing
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An active management approach attempts to outperform the market, defined as the index to which it benchmarks its performance, by "taking bets”. In investing the bets are:

  • Owning more of a stock than the underlying index, betting that name will outperform
  • Owning less of a stock than the index, betting that name will under perform
  • Owning a name that is not in the index at all

As the name implies, an active management approach requires building and selling these positions reflected in the fund’s turnover ratio. Commissions incurred when buying and selling names is expensive. Building and supporting an investment research platform is costly and these expenses are passed onto investors through higher annual expense ratios Finally, there are tax costs when you own the mutual funds in a non-qualified account.

As a result, to break even the performance of an active manager must exceed that of the index + these costs. While some do, it is extraordinarily difficult to do so consistently over time. It is even more difficult to determine in advance 1) who has the ability and 2) when they no longer do.

A passive management approach replicates an index. An example is the S&P 500 index which consists of five hundred companies, primarily American and large cap, selected by the S&P committee each year. Generally half the names are value-oriented companies and other half growth oriented. Over time this index has been a good proxy for the U.S. stock market in general.

Other common indexes are the

  • Russell 1000 Growth
  • Russell 1000 Value
  • MSCI EAFE
  • Barclays U.S. Aggregate Bond

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