The Great Debate: Active vs Passive Investment

Investors have been debating the merits of “active” versus “passive” investing for quite some time now. Active investing refers to a type of investment strategy where investors regularly buy and sell investments based on their analysis. These investors tend to conduct their own research by reading up on the companies’ business models and taking the time to read their financial reports to determine if they are worth investing in. Passive investing refers to the type of investment strategy where an investor believes that a diversified basket of common stocks, held at the lowest possible cost, with minimal trading, will tend to produce a market average return in the mid to long term.

Active investors believe that it’s possible to beat the market by buying stocks of companies with good prospects and sell off stocks of companies with bad prospects. In this case we’ll refer to active investment through investing in active managers (mutual funds). Passive investing takes the opposite view. Passive investors don’t believe that it is possible to select companies and profit from them. They tend to take it that the current price of the stock reflects all available information about the company and theoretically there is no extra work to be done to earn any additional returns.These passive investments refer more to Exchange Traded Fund (ETF).

So, should you engage in active investing or passive investing? Before you make any decisions, here are some key details you need to consider.

 

Active investing, a hands-on approach

If you are a strong believer that financial returns can be made through research, you can either pick your own stocks or invest in actively managed mutual funds. Mutual funds are offered by mutual fund companies such as Blackrock and Fidelity. These companies hire fund managers to invest the money pooled together from investors. Generally speaking, the goal of the fund manager is to “beat the market”, or in other words, outperform certain standard market benchmarks. For example, if you are investing in a US equity mutual fund, the fund manager’s goal may be to achieve better returns than the S&P 500. These managers actively seek for investments based on their assessment of each security’s worth. For the managers’ effort, the investors will naturally need to pay a fee.

 

Passive investing, an easier way to invest?

Taking a passive investing approach would mean that you prefer a buy-and-hold portfolio strategy, with minimal trading in the market. Passive investors don’t seek to profit from short-term price fluctuations or market timing and are happy to try to receive the performance of a market index. An efficient way to invest into such a passive strategy will be to buy an ETF. ETFs are funds that aims to offer you investment returns similar to that of an index like the S&P 500 or Straits Times Index (before fees). ETFs are traded like a stock and some of the major ETF providers include iShares, Xtrackers and Vanguard. Similar to a mutual fund, ETFs gives investors access to a portfolio of equities, bonds and other asset classes.

 

These are some notable differences between active and passive investing:

  • ETFs aim to give you “market” returns while active managers aim to beat the market

  • ETFs have lower fees while mutual funds charge higher fees to compensate the investment team for their research, trading and administrative costs

  • ETFs are more transparent with their holdings and often provide the list of holdings for their ETFs while active managers might be more reluctant to share their list as it could take away their competitive edge

 

Some prevail but many fail

In general, most actively managed funds fail to beat their benchmarks, especially over longer time horizons. According to Morningstar, only 24% of all active funds topped their average passive rival over the 10-year period which ended December 2018. Long-term success rates were generally lowest among U.S. large-cap funds.

 

So, which investment strategy should you choose?

Active strategies benefit investors in certain investing climates, and passive strategies tend to outperform in other climates. Generally, when the market is more volatile, it’s a more conducive investment environment for active investment strategies. During times of heightened market uncertainty, there’s a greater disparity in the perceived valuations of stocks which gives managers more opportunities to use their judgment and skills to take advantage of any mispricings. Increased market volatility may also spur managers to engage in risk management strategies to insulate the portfolio from any market pullbacks.

On the other hand, when stocks are generally highly correlated and are moving in one direction, passive strategies may be the better way to go. Also, active management has historically been proven more difficult within some areas of the market. According to the research done by S&P Dow Jones Indices, US large-cap funds have been having a tough time beating the S&P 500 index. As a result, it may make sense to take a more passive approach and invest in an ETF when trying to get an exposure to large US companies.

This debate of active vs passive has been going on for decades and will probably continue. So, instead of trying to pick a side, you may stand to benefit from utilising both passive and active strategies to leverage on the valuable attributes of both.

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