Active and passive investing has been at the forefront of financial debate in recent years. Experts and analysts have strong opinions on the topic but there is no debate that both parties have valid points to consider when tackling this sensitive subject. This article aims to provide the relevant information to equip investors and traders with the correct tools to make informed investment decisions when faced with the active versus passive investing conundrum.
What is Active Investing?
Active investing is the process by which a portfolio manager selects suitable investments based on the independent valuations in order to outperform a specific benchmark index or percentage return.
What is Passive Investing?
Passive investing is a portfolio management strategy where the objective is to match a specific benchmark index, such as the S&P 500 or the Dow Jones Industrial Average, or percentage return, usually by investing in similar stocks proportionate to the underlying benchmark index.
What is the difference between Active and Passive Investing?
1. Cost
Generally speaking, active investing carries a higher cost relative to passive investing. The reason behind this is twofold. The greater number of trades involved in active trading leads to higher trading costs and ultimately a higher overall cost. Secondly, research analysts and portfolio managers are required to be more ‘hands on’ which incurs greater time investment and additional cost.
2. Risk
Active investing often incorporates higher risk which can lead to better returns. However, in many instances, active investing fails to beat benchmark returns making passive investing beneficial in such circumstances.
3. Capital Gains Tax
Passive investing strategies involve a ‘buy and hold’outlook which usually leaves investors with minimal CGT for the year, while active strategies can result in larger CGT which is less tax efficient.
4. Receptiveness
Passive investment does not allow for much flexibility and limits investor exposure to possible undervalued stocks while any overvalued stocks would remain as the basket of stocks are effectively locked in from the outset. Active investing gives portfolio managers the ability to react to market conditions and ensure appropriate risk management if required.
During periods of high volatility, active investing may offer the superior risk-adjusted return although passive investing has exponentially increased in popularity.
Types of Active and Passive Investment Strategies
Active Equity Strategies:
These strategies can be designated into two broad categories namely, fundamental and quantitative investments. Fundamental investments involves utilizing human judgement to formulate investment decisions while quantitative investment approaches are data centric including the use of models and rules in a more systematic approach.
Passive Equity Strategies:
Passive strategies rely heavily on a sound understanding of the underlying benchmark index to accurately track index performance. Details such as onshore/offshore exposure, market capitalization, stock weightings, M&A and index rebalancing are just some crucial factors to consider.
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Active Investing |
Passive Investing |
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Equity Investing Strategies |
Fundamental:
Quantitative:
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Active vs Passive: Which Investment Strategy should you choose?
Many studies have been pitting the two strategies against each other with the general conclusion that both active and passive investing contains individual advantages in specific market conditions. Combining the two may lead to the ideal outcome for investors should the strategy exploit their respective advantages.
This being said, investor goals and risk appetite should always be at the forefront when deciding on financial investments. For conservative or risk averse investors focused on lower fees and tax, a passive strategy may be more suitable, while a risk seeking investor who may not be agitated by higher costs and tax may prefer an active investing strategy.
Points to consider when selecting an investment strategy:
- Risk appetite
- Personal financial goals
- Investment time horizon
- Cost
Active vs Passive Investing: A Summary
In conclusion, investors need to consider all aspects encompassing both active and passive investing with regard to their investment goals, risk appetite and cost. This should allow for the most suitable decision to be made for an optimal outcome. From an analyst/portfolio management perspective, the best method will continue to be debated but each to their own. The ultimate goal is for superior returns and regardless of method, if the numbers continue to exceed expectations/benchmarks then by all means continue with the approach that works for you!
Note: Traders should be aware of risks of loss to both active and passive investing. The possibility exists that you could sustain a loss in excess of your initial investment. You should be aware of all the risks associated with active and passive investing and seek advice from an independent financial advisor if you have any doubts.
Contact and follow Warren on Twitter: @WVenketas
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