By Xavier Brenner If you spend any time reading Wall Street asset management literature or personal finance sites, you've doubtless run across the terms "active" and "passive" investment management. These are widely used but often thinly understood concepts. On top of that, active and passive investor advisors are often framed as two hostile camps with diametrically opposed aims. In fact, they really represent two different strategies of creating wealth and can often work in tandem.
Camrys and Maseratis
The usefulness of an active or passive approach often depends on the risk tolerance, time horizons and financial goals of the individual investor. Just as there is a big difference between a practical family sedan like the Toyota Camry and a luxury sports car like a Maserati, investing strategies have different attributes and styles.
Passive investment managers invest in broad sectors of the economy through asset classes or indexes. The aim is portfolio diversification and steady performance. It's a no-frills approach but has some built-in advantages for investors. Passive strategies often buy low-fee exchange-traded funds that replicate the broad universe or S&P 500 Index stocks or the fixed income market. Because funds change their lineup infrequently, transaction costs and capital gains tax are minimized. With a passive investment strategy, you don't have to spend a big chunk of time researching individual stocks, so the fees tend to be lower as well.
Active strategies are overseen by investment professionals as the goal is to outperform the broader market in various asset classes. Such managers spend a lot of time searching for attractive stocks, bonds, and mutual funds, thinking about market movements and placing leveraged bets on the future direction of securities and other investments. Active managers come in all flavors.