We all want our portfolio to perform well so we can reach our financial goals. But in building a portfolio, investors are faced with a seemingly endless number of choices, including how the investment is managed. Both active and passive management styles offer their own own merits and drawbacks. So, the more you know about them, the better off you'll be when making investment decisions.
Pros and cons of passive management
Managers of passive mutual funds and exchange-traded funds strive to mirror the return of a particular index -- nothing more, nothing less. In passively managed funds, buy and sell decisions are based purely on the contents of the underlying index, not on research.
But because passive fund managers make no active decisions, this results in less trading. The diminished amount of trading both increases tax efficiency and reduces fund expenses. And as more dollars funnel into the ETF market, economies of scale kick in, making these funds even cheaper for us to own. But for as quickly as the 20-year-old ETF market has grown, only 3% of U.S. households own an ETF.
So when might I consider an ETF?
Many studies have tried to conclude whether active or passive management styles outperform over time. These studies indicate that asset class can often influence performance results. For example, for large and relatively efficient asset classes, like large-cap stocks and investment-grade bonds, it may be tougher for an active fund manager to outdo an index. This certainly doesn't mean active managers can't outperform the index they're stacked up against. It just means that the environment for doing so is more challenging in these well-established asset classes.
For these asset classes, investing in passively managed funds may be beneficial. Some large-cap equity ETFs to consider include Vanguard Total Stock Market ETF (NYSEMKT:VTI) and State Street's SPDR S&P 500 ETF (NYSEMKT:SPY), the world's largest ETF . Both provide inexpensive alternatives to participate in the overall stock market. For investment-grade fixed income, consider Vanguard Total Bond Market ETF (NASDAQ:BND) to add plain-vanilla bond exposure to your portfolio.
When not to invest passively
On the other hand, active managers and individual investors willing to conduct a deep-dive analysis have a great opportunity to outperform in less-efficient asset classes, like international, mid-cap, and small-cap equities. If you're a do-it-for-me investor, consider going with actively managed funds for these asset classes. Or, if you're a do-it-yourself investor, this is a prime opportunity to research and select great stocks to augment your portfolio.
Start by studying what stocks savvy investors are buying and why. For example, billionaire and money manager Ken Fisher recently added Darling International (NYSE:DAR) to his hedge fund. The Texas-based company provides recovery and recycling services of cooking oil for the food industry. Darling faces lower finished product prices that may dampen earnings, but its biodiesel joint venture with Valero Energy shows real promise. Our Motley Fool CAPS community also likes the stock and gives it a five-star (out of five) rating.
And look no further than our own Motley Fool co-founder David Gardner for some sensational ideas. He recently extolled the virtues of 3D Systems (NYSE:DDD) and Stratasys, pioneers in the disruptive 3-D printing technology. The World Economic Forum's Global Agenda Council on Emerging Technologies recently named this technology one of the most promising trends of 2013. As it's still in its infancy, David feels that 3-D printing is analogous to the Internet 15 years ago.
Foolish bottom line
Of course, there's no one-size-fits-all perfect investment. And there's no perfect answer for how to structure your portfolio. Both active and passive management can play critical roles. But the first step in crafting your portfolio is evaluating what you want from your investments and prioritizing what's most important to you.