Considering active vs. passive investment management

It doesn't have to be an either/or decision.

When building or adjusting your investment strategy, do you want active management, passive management, or a combination of both? It's important to understand fully how each approach works, and the differences between them.

Active management: Benchmark outperformance is the target
With an actively managed fund, a fund manager tries to outperform a particular benchmark for stocks—such as the S&P 500, or for bonds, the Bloomberg U.S. Aggregate Bond Index. How do active managers try to beat the index? The answer varies from manager to manager, but common ways include taking more (or less) risk than the benchmark, or owning more (or less) of a particular security or sector within the benchmark. They can even decide to own securities that are not in the underlying benchmark.

Passive management: Matching benchmark performance is the goal
With a passively managed fund, the fund is designed to match the performance of an underlying benchmark, like S&P 500 or Bloomberg Aggregate Bond. Passive fund managers can own all the stocks in the index to match its performance. They can also aim to mirror the performance of the index by owing a smaller subset of the underlying securities. 

Benefits of passive investing
With passive investing, there is no fund manager paid to choose individual stocks or bonds, and most index funds charge ultra-low fees that are below those of active funds. Index funds buy and then hold securities as they are added to the index, rather than frequently trading stocks or bonds. This can translate into lower capital gains taxes for individual shareowners.

"Regardless of your situation, remember that deciding which type of fund to buy doesn't need to be an either/or proposition. Many investors use a mix of index funds and actively managed funds in their portfolios."

By investing in an S&P 500 fund or a bond market index fund, you know your returns will at least match those underlying indices. Passive investing can be appropriate for investors who don't have the time or interest to monitor their investments frequently.

Benefits of active investing
Following the recession and The Great COVID Evolution brought on by pandemic-related shutdowns in early 2020 (one of three transformational themes that TIAA's Investment Management Group sees driving markets this year), the economic recovery in the U.S. is now at a mid-point in both the market cycle and business cycle, according to John Canally, Chief Portfolio Strategist for the TIAA Investment Management Group. We'll remain in mid-cycle, he believes, for the next few years.

An active investment strategy doesn't apply only to stocks. Fixed income investments like bonds can also benefit from an active investing approach, especially when yields are particularly low.

Sometimes, where you are in your own financial journey can determine whether active or passive investing is the right path for you. For example, retirees seeking income today may struggle given low interest rates combined with rising inflation. Active fixed-income fund managers can help retirees find yield sources not typically held by index funds, such as structured credit. They can also seek out fixed-income investments that may be less sensitive to inflation's impact on the bond markets, says Canally.

"Often, the devil is in the details for success when investing in fixed income," says Canally. "That's the advantage of an actively managed strategy. An active manager can tailor the portfolio to meet your needs in bonds. If you're not aware of that, you may miss out on asset classes such as high yield bonds or emerging market bonds, which can help your situation."

During mid-cycle periods like we're in, when volatility and rising interest rates have active investors' attention fixed on things like stock valuations (that's the fair value of an asset), there's an opportunity to get better value for certain stocks. Passive investments, which comprise a fixed bucket of stocks without regard for their current value, aren't designed to take advantage of these fluctuations in the market.

"Valuations now matter more than they did in the last few years," says Michael Sowa, Deputy Chief Investment Officer in TIAA's Investment Management Group. "Active managers can select the stocks they feel are a good value relative to their performance."

Passive: Balancing pros and cons
In the early stages of a recovery, most stocks tend to perform well, benefitting a passive investing approach, says Canally. On the downside, investors in emerging markets who invest through an index fund may see the majority of those funds allocated to China, given the size of that country relative to other markets, he says. That can cause a risk of overconcentration when an investor may be seeking diversification through international investing.

Active: Balancing pros and cons
However, individual stock selection may be more useful during mid- to late-market cycles. Following the economic rebound in 2021, the global economy began to slow with a new COVID-19 variant in November, inflation rising to a 40-year high, federal stimulus money drying up and rising interest rates as the Fed began to try to slow inflation. The war in Europe has only exacerbated concerns over inflation, powered by the run-up in motor fuels prices—factors all contributing to continued significant market volatility. The bottom line for active investing? In an economy where Volatility is the Next Normal (another transformational theme this year), uncertain markets tend to favor an active investment approach, and professional management can help smooth out the rough ride.

However, even in an environment that may favor active investing, it can bring downsides. For one, your fund manager may underperform the S&P 500 or other benchmark index if they make poor investment selections, or the fund's higher fees cut into performance returns.

"A lot of things that typically work in the early part of the cycle start to lag when the early phase dies out, and investors grow concerned about slowing growth and the Fed getting involved," Canally says.

Some stocks perform better against these headwinds, explains Canally. For instance, strong companies can often raise prices in the face of inflation without sacrificing sales. Active managers can do the research to seek out these higher-quality companies, which are better able to weather an economic slow-down.

The best choice might be a mix
"Regardless of your situation, remember that deciding which type of fund to buy doesn't need to be an either/or proposition. Many investors use a mix of index funds and actively managed funds in their portfolios to combine the cost advantage of indexing with the possibility of outperforming the market with active funds," says Canally.

The value of professional management
Our current market and geopolitical environment is making investment selection even more challenging. Active investors can benefit from professional monitoring of the performance of an actively managed fund—and of the fund manager. The outcomes of an actively managed fund can vary widely from a passively managed fund.  Professional oversight of the fund, like you get in TIAA's managed accounts, is an advantage.

TIAA managed accounts offer professional management to help you feel confident your portfolio is aligned with your goals and investment style, especially during continued volatility. Your TIAA advisor will work with you to construct a well-diversified portfolio that suits your unique needs and goals, and help you determine the right mix of active and passive investments depending on your current situation.

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TIAA managed account services provide discretionary investment management services for a fee. Investing involves risk and the value of your investments may gain or lose value and fluctuate over time. Investments in managed accounts should be considered in view of a larger, more diversified investment portfolio. TIAA managed account services are offered through two separate managed account programs offered by TIAA affiliates: the TIAA Advice and Planning Services Portfolio Advisor program ("Portfolio Advisor") offered through Advice and Planning Services, a division of TIAA-CREF Individual & Institutional Services, LLC, Member FINRA, a registered investment adviser, and the Private Asset Management program ("Private Asset Management") offered by TIAA, FSB, a federal savings bank. Please refer to the disclosure documents for the Portfolio Advisor and Private Asset Management programs for more information.

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