Active vs. Passive Investing

One of the most fundamental decisions in portfolio management is whether to pursue an active or passive investment approach. This choice has profound implications for portfolio construction, costs, tax efficiency, and expected returns. Understanding both approaches—and the theoretical framework behind them—is essential for CFP professionals advising clients.

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Active Investment Management

Active management is an investment approach where portfolio managers attempt to outperform a benchmark index through security selection, market timing, or both. Active managers believe they can identify mispriced securities or predict market movements to generate returns exceeding those of a passive benchmark.

Active Management Techniques

Arguments for Active Management

• Market inefficiencies: Some markets or segments may be less efficient, offering opportunities for skilled managers
• Risk management: Active managers can potentially reduce downside risk during market stress
• Flexibility: Can adapt to changing market conditions and opportunities
• Niche expertise: Specialized knowledge in specific sectors or asset classes
• Behavioral advantages: Disciplined approach may avoid common investor mistakes

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Passive Investment Management

Passive management (also called indexing) is an investment approach that seeks to replicate the performance of a market index rather than attempt to outperform it. Passive investors accept market returns while minimizing costs.

How Indexing Works

Index funds and ETFs use several replication methods:

Advantages of Passive Management

• Lower costs: Expense ratios typically 0.03%-0.20% vs. 0.50%-1.50% for active funds
• Tax efficiency: Lower turnover means fewer taxable events
• Diversification: Broad market exposure reduces unsystematic risk
• Transparency: Holdings match the published index
• Consistency: Returns closely track benchmark performance

CFP Exam Tip: Remember that passive investors accept that consistently beating the market after costs is extremely difficult. They focus on capturing market returns efficiently rather than trying to outperform.

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The Efficient Market Hypothesis (EMH)

The theoretical foundation for passive investing is the Efficient Market Hypothesis (EMH), developed by economist Eugene Fama. EMH posits that security prices fully reflect all available information, making it impossible to consistently achieve above-market returns through analysis or prediction.

Three Forms of Market Efficiency

Implications by EMH Form

Weak Form Efficiency:

• Past prices contain no predictive information about future prices
• Chart patterns and technical indicators are useless for generating alpha
• Prices follow a "random walk"—future movements are unpredictable from past patterns
• What still works: Fundamental analysis may add value

Semi-Strong Form Efficiency:

• Stock prices adjust rapidly to new public information (earnings, economic data, news)
• Fundamental analysis of public information cannot generate consistent excess returns
• Active managers using publicly available research cannot outperform
• What still works: Only private (insider) information could generate alpha

Strong Form Efficiency:

• Even insider information is reflected in prices
• No form of analysis or information provides an advantage
• Markets are "perfectly" efficient
• What still works: Nothing—only accept market returns through indexing

CFP Exam Tip: Semi-strong form efficiency is the most commonly referenced form. It supports passive investing because it suggests that analyzing public information (financial statements, economic data) cannot reliably generate excess returns.

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SPIVA Research: The Evidence on Active Management

The SPIVA (S&P Indices Versus Active) Scorecard provides the most comprehensive ongoing research comparing active fund performance to benchmark indexes. Published by S&P Dow Jones Indices, SPIVA data consistently demonstrates the challenges faced by active managers.

SPIVA Key Findings (Mid-Year 2025 Data)

Note: SPIVA data updated semi-annually. Short-term underperformance varies by market conditions; long-term patterns consistently show increasing underperformance over time. As of October 2025, passive funds hold 54% of U.S. fund market assets ($19 trillion), surpassing active funds for the first time.

Critical SPIVA Insights

1. Time matters: Underperformance rates increase dramatically over longer periods. While 35% of large-cap managers might outperform in any given year, only about 8% maintain outperformance over 15 years.

2. Survivorship bias: SPIVA accounts for funds that close or merge. Over 20 years, nearly 64% of domestic stock funds were shuttered or merged—often due to poor performance.

3. No safe categories: After 15 years, there are no categories in which a majority of active managers outperformed their benchmarks.

4. Fixed income struggles too: More than 50% of fixed income funds underperform their benchmarks over 10 years.

5. Persistence is rare: Funds that outperform in one period rarely maintain outperformance in subsequent periods.

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The Cost Difference: Why Expenses Matter

One of the primary explanations for active manager underperformance is costs. Active funds incur expenses that passive funds largely avoid.

Expense Ratio Comparison

The Compound Effect of Costs

Consider the long-term impact of a 1% expense difference on a $100,000 investment earning 8% annually:

A 1% annual expense difference reduces final wealth by over 25% over 30 years.

CFP Exam Tip: When recommending investments, always consider the impact of expense ratios. The CFP Board expects candidates to understand that costs directly reduce returns and compound over time.

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When Active Management May Add Value

Despite the evidence favoring passive investing, active management may be appropriate in certain situations:

Potential Active Management Opportunities

The Active/Passive Decision Framework

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Summary: Making the Active vs. Passive Decision

The choice between active and passive management should be based on:

1. Cost analysis: Active management must generate enough alpha to overcome its higher costs
2. Market segment: Some markets are more efficient than others
3. Tax considerations: Taxable accounts favor lower-turnover passive strategies
4. Client beliefs: Some clients prefer the potential (however unlikely) for outperformance
5. Time horizon: Longer horizons favor passive approaches due to compounding cost savings
6. Manager selection ability: If choosing active, can you identify future outperformers?

The empirical evidence strongly supports passive investing for most investors in most situations. The CFP professional's role is to help clients understand this evidence while respecting their preferences and unique circumstances.