Passive ETFs are also more tax efficient. Because they track indexes, they don’t frequently buy and sell individual stocks and therefore don’t tend to rack up large capital gains bills, unless the investor exits their position.
“Passive investments are lower in cost, provide broad market exposure and are more tax efficient than active investments,” said Jason Dall’Acqua, president of Crest Wealth Advisors. “However, passive investments provide no risk management — you own the best and the worst companies of the index the investment tracks.”
Argument for Active
The typical outperformance of passive funds was flipped on its head in the first half of this year, with 58% of large-cap mutual funds beating their benchmarks through mid-May, according to research by Strategas Securities.
Those funds still posted a 12.3% decline on average, but that was better than the more than 17% drop in the S&P 500 over the same period.
The reason for the outperformance was active managers’ underweight positions in those same megacap tech stocks that performed so well during the bull market, but slumped as investors began to grow more fearful of inflation and a potential recession.
“If you’re outperforming on the downside, that has a risk-management benefit to you as an investor and that shouldn’t be underappreciated,” said Dan Hunt, head of portfolio construction and investment tools at Morgan Stanley.
While it can be difficult for active managers to add much value in widely traded sectors like large-cap stocks, it’s easier for them to outperform in less liquid areas like fixed income and small-cap stocks, Dall’Acqua said.
To offset the potentially higher tax bill that comes with active management, Hunt suggests putting those investments in a Roth account, which allows tax-free withdrawals in retirement, or a tax-deferred account like an IRA or a 401(k). They can also be useful for tax-loss harvesting.
Case for a Mix
The best solution for many investors may be a mix of both passive and active investments.
“In our view, we think that both can have an enduring role in a client’s portfolio,” said Dan Reyes, head of the portfolio review department at Vanguard Group Inc.