Active vs Passive Investing

Introduction:

When deciding where to allocate your excess capital, there are 2 main strategies that investors use to categorise their investments: active or passive investing. Investors base their strategy on a few key points:

- The amount of time they can dedicate to keeping up with their investments

- Their knowledge of the stock market

- Risk appetite

Whilst there are advantages/disadvantages for both, it depends a lot on both your investment goals as well as how you want your investing experience to be. In this article we will explain what each method of investing entails, as well as some advantages/disadvantages for both.

Active Investing:

As the name implies, active investing is a more hands-on approach that requires a portfolio manager who closely handles the investments of clients. Active money management aims to beat the average returns of the stock market and capitalise on short-term pricing fluctuations or concepts such as arbitrage. The goal of portfolio managers is to predict the price movements of certain securities (e.g., stocks or bonds) and profit from them by either going 'long' or ‘short’ on the security.

Portfolio managers usually rely on a team of analysts who do a lot of analysis on both quantitative (e.g., discounted cash flows) and qualitative (management) factors that may affect a securities price. These analysts spend their time trying to work out the ‘target price’ of a security, and once they have determined this price, they can decide whether they should buy it or not. One of the benefits of investing in a hedge fund or other actively managed fund is that they are often Long/Short, meaning that they are able to profit in times of bull markets AND bear markets.

Active investing requires investors to be ‘accredited’, meaning that investors must meet criteria such as having a net worth of >$1 million and understands all the risks involved with trading. The reason for this is because often times active managers use complicated investment techniques that take years to understand. Therefore, a lot of people may not know exactly where their money is actually going which can be dangerous.

Advantages of active investing:

- Flexibility: Active managers aren’t required to hold a 'basket' of stocks and therefore have the ability to find ‘diamond in the rough’ stocks and make huge profits if it does well.

- Hedging: Active managers can profit in both bull and bear markets due to their ability to long or short stocks. This means that active managers can profit off of stocks doing badly, as well as exit positions that may be losing them money. In a passively managed funds, you are often stuck with your basket of stocks no matter their performance.

- Tax management: active managers are able to tailor their tax management strategies to the individual investors. For example, managers can sell investments that are losing money to offset the taxes on their very profitable investments.

Disadvantages of active investing:

- High fees: The average expense ratio for an actively managed fund is 1.6% compared to 0.6% for a passively managed fund. The reason they command these higher fees is because of (a) the time/expertise that goes into picking the best stocks and (b) the transaction costs from the high volume of buying/selling securities.

- High risk: Although flexibility is a great asset for active managers, it can also lead them to very poor returns. Due to the pressure on active managers to get higher than average returns, they must deploy some higher risk investment strategies. When these go well, their returns are great and everyone is happy, however, historically these active managers such as hedge funds have underperformed the market due to their high-risk strategies.

Passive investing:

In contrast to active investing, passive investing aims to track a benchmark or index without outperforming the market. It is a popular way of investing amongst non-accredited investors that either don’t have the time or expertise to pick out specific companies and go through all of the necessary valuations to accurately predict whether it is a good stock or not.

Through a passive investment strategy, the investor buys a market-based index fund, such as Vanguards VOO which tracks the S&P 500 (the S&P 500 tracks America's 500 largest companies). This index fund will buy fractional shares in each of the companies in the S&P 500 which will make your portfolio extremely diversified and therefore lowers the risk of your investments.

For the average investor without extensive knowledge of the stock market, these index funds are a place for them to realise slow but consistent long-term gains as the economy prospers. On average these index funds return around 10% annually to investors. If you are able to start early and stay disciplined with investing your income over 30 years, then the power of compounding will put you in a very healthy financial position when it comes to retirement.

Advantages of passive investing:

- Low cost: These index funds are charge extremely low fees due to the ‘hands-off’ investment strategy they use. Unlike active managers they don’t incur many transaction fees as there is not much buying/selling of stocks, it follows a buy/hold strategy.

- Low time commitment: These funds don’t require much upkeep and once you have put your money in there you don’t need to continually move it around buying/selling more stocks.

- Consistent returns: On average, index funds have outperformed active managers with average returns of 10% annually. Although the market doesn’t always return 10%, over the long term if you keep your money invested then it will come to 10% annually.

Disadvantages of passive investing:

- Inability to profit off of bear markets: During bear markets, index funds aren’t able to ‘short’ the market and benefit off of falling prices. If you were invested in an actively managed fund, the portfolio manager can use complex techniques to profit off of falling share prices.

- Potentially lower returns: Index funds will bring investors consistent returns however they are unlikely to yield a 30% annual return like hedge funds might. This is because of the diversification brought by index funds that lowers the risk/return ratio.

Conclusion:

For the majority of investors, passive investing is the best decision to grow their money long-term. Investing in an index fund over a 30-year period have historically yielded 10% returns. With the power of compound interest, as long as you start investing early then a 10% return will leave you in a great position for retirement as long as you stay disciplined with putting money into your investment portfolio.

If you’re looking to secure above average returns, then you should look into active managers such as hedge funds. There are many different types of hedge funds that specialise in different areas, such as equities, credit etc., so make sure to do your research on the past performance and outlook of the fund.