ACTIVE VS. PASSIVE INVESTING

Active investment management involves buying and selling stocks of individual corporations. Investment decisions are driven by a desire to buy stocks of those companies that the investor believes the rest of the market has under-valued and to sell those stocks the investor believes the market has over-valued. In other words, active investors believe that they can "beat the market." This management style also involves trying to "time the market" in order to be more heavily invested when the market is rising and less so when the market is falling.

Academic research has shown that over a long-term investment horizon, actively managed investment portfolios and mutual funds are likely to underperform an investment portfolio consisting of index and exchange traded funds. There are a variety of reasons why this is likely to be the case.

The first is that the stock market is efficient; what is currently known about a company is already reflected in the stock price. As a result, at the same time some "experts" are recommending that a stock be purchased, other "experts" are recommending that it be sold. Unfortunately, neither of these so-called experts knows whether the next piece of information that will ultimately determine the direction of the stock price will be favorable or unfavorable (unless, perhaps, they are engaging in illegal insider trading).

Actively managing a portfolio also typically results in higher expenses, which must be recouped in order to simply match the performance of a portfolio consisting of passive investment vehicles. In addition to trading costs, actively managed portfolios must absorb the difference between the "bid price" (the price at which traders will buy) and the "offer price" (the price at which traders will sell) on each transaction. Because actively managed funds, by definition, trade more often, they will incur the cost of this bid-offer spread more frequently.

Finally, a portfolio or mutual fund that is actively managed must overcome the tax burden associated with the frequent buying and selling of securities. Typically, an actively managed mutual fund sells about 80% of the stocks in its portfolio each year. And, because the IRS requires that mutual funds distribute at least 98% of their realized income each year, investors in actively managed funds must pay ordinary income or capital gain taxes on the distributions that result from this high turnover.