About 30 years ago, professional investors conducted a lively debate about the merits and deficiencies between active and passive management.

At the time, there were two distinct camps. There were purists on both sides and each insisted that the one of the strategies was demonstrably better than the other. 

Since 1973, when the first paper formalizing the distinctions between active and passive portfolios was published, the active-passive debate has become one of the investment industry’s most discussed issues.

Today, index funds remain very popular in the U.S. As of year-end 2008, there were 368 index funds managing total assets of $604 billion, including net new inflows of $34 billion in 2008 alone, according to the 2009 Investment Company Institute Fact Book. 

As a result of these new inflows and new competitive products, the once-clear lines of distinction between the two approaches have melded into a continuum. Many investment professionals acknowledge the benefits of both active and passive investing, especially when used in combination with different investment managers and investment styles.

“Both approaches have a place in an institutional portfolio.  How much active versus passive to include depends upon several factors, such as current market conditions, the fund’s position in the investment cycle, and how confident investors are in their ability to deliver excess portfolio return with the accompanying higher risk level.”

While many people think institutional investors prefer active management, there are times when large investors use index funds.  This happens when a large fund fires a manager and then hires another.  The period between this handoff is a critical period because it could mean that hundreds of millions of dollars that were overseen by one manager are now in flux for a short period.  During this transition period, many large funds buy an index fund for a brief period so they can continue to track market performance.

While this debate between passive and active management was once clearly delineated, more sophisticated investment structures today employ both active and passive approaches.

Passive, But Not Inert

The underlying question in any discussion about active and passive management is the degree to which managers add value to a portfolio above a market index.  This raises the key question: Can the active manager deliver performance that justifies the fee they charge compared to the small fee charged by a passive manager, such as an index fund?

Passive management assumes that the average returns of all investors will be equal to the returns of the average active managers. At all times, some investors will be above average, some below.

 The passive approach rests on the assumption that there is no systematic active approach that will always be above average and, therefore, randomly selecting from the universe of active choices should produce — on average — market-like returns. Since active managers charge higher fees than passive approaches, just “average” active results will not match passive results, especially when investors factor in net-of-fee performance.

The Active and Passive Continuum

So if passive investors believe they have the better strategy, how can investors who believe in active management improve their odds of success?  In order to beat the outcome of randomly selected managers, investors need some way to distinguish those products that possess better than even odds of success.

The greatest distinction between active and passive investing is the belief that information and expertise-rich investment processes can produce outstanding portfolio outperformance.

This gives many investors who believe in active management the opportunity to invest in a wide variety of active investments. 
The risks and returns of active and passive portfolios all come from exposures to different investment styles, sectors, and individual characteristics. The choice of these portfolios will vary based on investor objectives and risk preferences.

Yet while these two investment approaches differ on a number of critical fronts, they can co-exist under the umbrella of a managed portfolio. In their book Modern Portfolio Theory, authors Andrew Rudd and Henry K. Clasing, Jr. noted that a managed portfolio could be comprised of two sub-portfolios: the active and the “normal” or unmanaged, passive one. The normal sub-portfolio is the core around which the active manager places bets by underweighting some stocks and overweighting others.

Today, many academics agree that investors can use both an active management approach in conjunction with a passive one. In practice, this means individual and institutional investors should consider both active and passive investment strategies, including the use of index funds and ETFs, as worthy additions to their portfolios and not as competing options.