Investors frequently diversify their portfolios between stocks, bonds, and cash, between different sectors of the economy, and geographically. However, an important but often overlooked type of diversification is active and passive management.

Active management

“Active management” means the investor actively chooses the individual holdings for his portfolio. If your asset allocation model calls for “large cap stocks,” you would choose specific companies to invest in or a particular mutual fund that invests in this sector.

Active management requires careful research before purchasing and constant watching to determine when and why to sell. An active investor might choose to hire a money manager to watch and actively trade the portfolio. Some actively managed funds have higher returns than passively managed funds, but keep in mind that the costs of active management will directly impact your returns.

Passive management

With passive investing, within the framework of your asset allocation model, you choose an Exchange Traded Fund (ETF), often a fund that tracks an overall segment of the market (often called an “index fund”),  that fits your criteria, such as “growth funds,” “global real estate,” or “corporate bonds.” You don’t choose the specific investments within – just the type of fund that interests you. Passive investors give up specific choices of assets for the comfort of knowing the overall mix of investments matches their asset allocation. Typically, passively managed funds’ fees are lower than those of actively managed funds because they don’t have as much trading going on inside and because there are no management teams that need to be paid.

Which is best?

Like many other investment decisions, it depends on you. One common tactic is to diversify your portfolio between active and passive investments. This way the part of your portfolio that is actively managed can respond to turbulent market conditions, while the passive part of your portfolio can target long-term returns.