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Though indexing a passive investment strategy has been used by institutional investors for many years, it is still moderately new for the characteristic individual investor. Because ETFs use predominately passive strategies the first question any investor should consider is whether to take an active or passive approach to investing.
The main investment strategy today is active investing which attempt to break the market. The objective of active management is to beat a particular benchmark. Most of the popular mutual funds are actively managed.
Analyzing the market trends the economy and the company-specific factor, active managers are continuously searching out information and assembly insights to help them make their investment decision. Many have their own complex safety selection and trading systems to realize their investment ideas, all with the final goal of outperforming the market. There are roughly as many methods of active management as there are active managers. These methods can include fundamental analysis, technical analysis, quantitative analysis and macroeconomic analysis.
Active managers consider that the markets are inefficient, anomalies and irregularities in the capital markets can be exploited by those with skill and insight. Prices react to information slowly enough to permit skillful investors to steadily outperform the market.
The main benefit of active management is the opportunity that the managers will be able to break the index due to their superior skills. They can make educated investment decisions based on their experiences, insights, knowledge and capability to identify opportunities that can translate into superior performance. If they consider the market might turn downward active managers can take suspicious actions by hedging or increasing their cash positions to reduce the impact on their portfolios.
A difficulty of that active investing is more costly resulting in higher fees and operating expenses. Having higher fees is a significant obstruction to preventing a manager from consistently outperforming over the long term. Active managers in an effort to beat the market tend to have a more determined portfolio with fewer securities. However, when active managers are wrong they may vary considerably under-perform the market. A manager's style could be out of favor with the market for a period of time, which could result in lagging performance.
Passive management or indexing is an investment management approach base on investing in exactly the same securities and in the same proportions. It is called passive because portfolio managers don't make decision about which securities to purchase and sale, the managers purely follow the same method of constructing a portfolio as the index uses. The manager’s objective is to duplicate the performance of an index as closely as possible. Passive managers invest in wide sectors of the market called asset classes or indexes and are eager to recognize the average returns various asset classes produce.
Passive investors consider in the Efficient Market Hypothesis (EMH) which states that market prices are always fair and quickly reflective of information. EMH followers believe that constantly outperforming the market for the professional and small investor alike is difficult. Therefore passive managers do not try to beat the market but only to equal its performance.
The main benefit of passive investing is that it closely matches the performance of the index. Passive investing require little decision-making by the manager. The managers try to duplicate the chosen index, tracking it as efficiently as possible. This results in lower operating costs that are passed on to the investor in the form of lower fees.
A passively managed investment will never outperform the underlying index it is meant to track. The presentation is dictated by the underlying index and the investor must be pleased with the performance of that index. Managers are unable to take action if they believe the overall market will decline or they believe person securities should be sold. A debate about the two approaches has been ongoing since the early 1970s. The researchers from the nation's institutions and privately funded research centers supporting the passive management. Banks, insurance companies and other companies that have a vested interest in the profits from active management support the other side of the quarrel. Each side can make a strong logical case to support their arguments even though in many cases the support is due to different belief systems much like opposing political parties. Even if each approach has advantages and disadvantages that should be considered.