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Active Management vs Passive Management: the Benefits and Drawbacks

2022.09.02 18:24:00 Minso Kim

[Photo Credit to Pixabay]

Eunyoung Choi, former CEO of an asset management company, elaborated on the pros and cons of active and passive management in an online interview. 

Ms. Choi emphasized that active management and passive management both have benefits and disadvantages in stock management: active management offers greater potential and customization, while passive management has relatively lower costs.

[Zoom interview with Ms. Choi, former CEO of Kingsley Asset Management: screenshot by Minso Kim]

As a short introduction, a stock market is a venue where investors buy and sell shares, or stocks, listed by companies. 

“As the prices of these stocks change based on supply and demand, with the demand for a stock rising when the company excels in the industry, investors purchase stocks of companies with high potential for growth in order to yield profit,” Ms. Choi states.

However, it is impossible to perfectly predict the rise and fall of prices on the stock market. 

“It’s not an exaggeration to say that the greatest desire of investors is to accurately predict the stock market,” Ms. Choi says. 

“Therefore, many investors seek help from professional financial managers,” says Ms. Choi. 

The services of these financial managers can be either human- or technology-driven.

In human-driven management, also known as active management, a fund manager analyzes the different choices available and makes decisions about buying, selling, and holding stocks.

“Active managers focus on outperforming the market, which means generating a better result than the market in general; this leads them to select only companies with great potential for growth,” elaborates Ms. Choi.

“Active managers may rely on quantitative resources, including research, forecasts, and data, as well as qualitative resources, including their personal experience and judgement. Active managers may even meet with the company to assess its credibility and approach the situation considering the unique conditions of each individual client. In addition, active managers can also consider long-term situations,” explains Ms. Choi.

As a result, they can provide clients with detailed explanations of the reasons behind their decisions. 

However, Ms. Choi states that all these benefits come with a cost; the average active management fee lies between 0.5 and 1.5% of the fund returns. 

This may not seem like a high percentage, but considering the size of the asset, the absolute value may be quite high. 

“Therefore, clients of active managers tend to invest in the long term and hold large amounts of assets,” Ms. Choi says.

On the other hand, there is technology-driven management, which is also known as passive management. 

“Passive management focuses on matching the performance of the market; this means that it replicates the index of a larger market, aiming to achieve similar results. Passive management views asset allocation from a more macro perspective. Although not as detailed and fundamental research-oriented, passive management tends to be a cost-effective and efficient way of constructing a well-diversified portfolio that can be less volatile than individual stock prices,” Ms. Choi says. 

The greatest attraction of passive management, Ms. Choi says, is its low management fees; the average cost is 0.2% of the generated profit. 

“Therefore, passive management is highly accessible even to investors with little experience,” Ms. Choi says.

So, what are the similarities and differences of active and passive management? 

Although the two share the common ground of portfolio management, there are more differences than similarities. 

“While active management selects individual stocks, passive management selects broad indexes with the potential for growth as a whole. As a result, active management aims to outperform the benchmark with a portfolio consisting of only selected stocks, while passive management intends to match the performance of the selected index,” Ms. Choi elaborates. 

This means that active management has higher risk but also greater potential for higher returns, while passive management tends to have lower risk but limited returns. 

“There are also limits in services driven by technology: passive management tends to lack flexibility, long-term vision, customization, and explanation when compared to active management. However, passive management compensates for these disadvantages with its low cost,” Ms. Choi explains.

The management fees for passive management are, on average, 0.8 percentage points lower than those of active management. 

To summarize, active management provides exclusive, individual service but has high costs, while passive management engages in a broader index without customization but has low costs.

“There is no perfect investment as every type of investment involves some sort of trade-off. Therefore, it is crucial to understand the advantages and disadvantages of the management types before making a decision,” Ms. Choi concludes.

Minso Kim / Grade 10
The American School in Japan