Q. What is the difference between active portfolio management and passive portfolio management? There appears to be a huge difference in costs for each approach.

A. Active portfolio management focuses on Investment Managers trading investments in an attempt to outperform a specific benchmark index. For example, an Australian Share Managed Fund may be benchmarked against the All Ordinaries Index.

Passive portfolio management seeks to replicate the return of a chosen index instead of outperforming it. As this investment strategy is not proactive, the management fees assessed on passive strategies are often far lower than active portfolio management strategies.

Active managers promote their funds to the market on the basis of their ability to generate greater returns than those achieved by simply replicating a particular index. Portfolio managers engaged in active management focus on factors that may impact the performance of specific companies within their portfolio.

At various times in the market cycle, active and passive management approaches will perform better. Investors will tend to invest into active management if there is evidence that the manage is outperforming the market nett of fees. Likewise, if the market is generally rising and active managers are struggling to outperform the market, it becomes challenging for the active manager to make the case for outperformance net of fees.

In a rising market, active managers may “swim against the tide” of passive fund inflows by making calls on shares that may be large in index weighting but the Fund Manager may feel are overpriced. When passive money continues to dominate new investment into the market, these stocks will continue to have price support that may not be warranted.

When money leaves the market and prices fall, passive investors with an index weighting bear the brunt of market exposure.

Generally speaking, in a falling market, active managers who invest in shares on the basis of a company’s fundamental qualities are more likely to outperform the broader market albeit at a higher management cost.

Passive Portfolio Management provides low-cost exposure to a particular market. However, the approach does come with inherent market risks that need to be considered as part of any long-term strategy. Pricing of this risk is critical in constructing a portfolio regardless of how cheap passive management or expensive active management may appear at any given stage of the investment cycle.