Quick Answer
Active management tries to beat a benchmark (typically higher fees, more turnover); passive replicates it, consistent with the Efficient Market Hypothesis. Growth targets above-average earnings growth at high valuations; value targets stocks below intrinsic value with a margin of safety. Income investing targets regular cash flow; capital appreciation targets long-term growth in asset value.
Now that you understand how portfolios are structured (strategies), you can explore how securities within those portfolios are selected. Investment style answers a different question: not "how much in each asset class?" but "what kind of securities do we pick?"
Active vs. Passive Management
The most fundamental style choice is whether to try to beat the market or simply match it.
| Feature | Active Management | Passive Management |
|---|---|---|
| Goal | Outperform a benchmark index | Replicate a benchmark index |
| How | Manager selects securities, weights positions, and may time trades to seek excess return | Holds all (or a representative sample of) index securities |
| Fees | Typically meaningfully higher | Typically meaningfully lower |
| Turnover | Typically higher (frequent buying/selling) | Typically lower (trades mainly around index changes, though flows, corporate actions, and rebalancing also trigger trades) |
| Tax efficiency | Typically lower in taxable accounts (more realized gains) | Typically higher in taxable accounts (fewer taxable events) |
| Foundation | Belief that skilled managers can find mispriced securities | Consistent with the Efficient Market Hypothesis (EMH): markets are efficient, so beating them consistently is unlikely |
Think of it this way: Active management is like hiring a personal chef who picks every ingredient. Passive management is like ordering a set menu that mirrors exactly what everyone else is eating. The chef typically costs more and might make a better meal, but statistically, the set menu wins more often over time.
Key takeaway: Over long periods, the majority of actively managed funds underperform their benchmark index after fees. This is the core argument for passive management.
Exam Tip: Gotchas
- Active management is not "better" or "worse." It depends on the market. Active managers may have more opportunity to find mispriced securities in less efficient markets (small-cap, international, emerging) where information is harder to obtain, though results vary by category and period and most active funds still underperform their benchmark after fees over the long run. In highly efficient markets (large-cap U.S. stocks), passive strategies tend to win.
- Passive management is consistent with the Efficient Market Hypothesis (EMH), but that does not mean markets are perfectly efficient in all segments, or that EMH is the only reason to go passive (cost, turnover, and diversification also matter). Less efficient markets (small-cap, emerging) give active managers more opportunity.
Growth vs. Value Investing
These two styles represent opposite approaches to stock selection.
Growth Investing
- Focuses on companies with above-average earnings growth potential
- Typically higher price-to-earnings (P/E) and price-to-book (P/B) ratios (investors pay a premium for expected future growth)
- Companies often reinvest profits rather than pay dividends
- Typically higher volatility (growth expectations may not materialize)
- Examples: technology companies, innovative disruptors
Value Investing
- Focuses on stocks trading below their intrinsic value (low P/E, low P/B)
- Companies may be temporarily out of favor or overlooked by the market
- Built on the margin of safety concept: buying at a discount provides a buffer against error
- Tends to be less volatile than growth investing, though particular value stocks or periods can still be volatile
- Examples: mature companies in established industries trading at discounts
| Feature | Growth | Value |
|---|---|---|
| Valuation | High P/E, high P/B | Low P/E, low P/B |
| Dividends | Low or none (reinvested) | Often higher |
| Volatility | Typically higher | Tends to be lower |
| Strategy | Pay a premium for future earnings | Buy at a discount to intrinsic value |
Exam Tip: Gotchas
- Growth stocks have higher P/E ratios because investors are paying for expected future earnings, not current earnings.
- Value investing requires patience. Undervalued stocks may stay undervalued for extended periods ("value traps").
Income vs. Capital Appreciation
These styles differ in what the investor prioritizes: current cash flow or long-term growth.
Income Investing
- Focuses on securities that generate regular income (dividends, interest payments)
- Typical holdings: bonds, preferred stock, dividend-paying stocks, REITs
- Suits investors who need current cash flow (e.g., retirees)
- Lower growth potential; income holdings such as bonds and preferred stock tend to be more predictable than growth stocks, though common stocks and REITs on this list still carry price volatility
Capital Appreciation
- Focuses on long-term growth in the value of assets
- Accepts lower or no current income in exchange for higher return potential (not assured)
- Typical holdings: growth stocks, small-cap stocks, emerging markets
- Suits investors with long time horizons who do not need current income
Exam Tip: Gotchas
- Income investing and value investing are NOT the same thing. Value investing looks for underpriced stocks (which may or may not pay dividends). Income investing specifically targets securities that generate regular cash flow regardless of whether they're undervalued.
What Should You Check on Exam Day?
- Active management tries to outperform a benchmark; passive management tries to replicate one, consistent with the Efficient Market Hypothesis (EMH).
- Active managers may have more opportunity in less efficient markets (small-cap, international, emerging), though results vary by category and period; passive tends to win in highly efficient markets (large-cap U.S. stocks).
- Growth investing pays a premium (high P/E, high P/B) for expected future earnings; value investing buys at a discount (low P/E, low P/B) with a margin of safety.
- Income investing targets regular cash flow regardless of valuation; capital appreciation targets long-term growth and can tolerate low or no current income.
- Do not equate income investing with value investing: value is about price versus intrinsic worth, income is about cash-flow generation.