The differences between active and passive investment have long been a subject of heated debate in the financial world. Walk into any room of investors and ask which strategy is better, and you are sure to ignite a storm.
Recently, there has been a good reason for such rivalry. In 2019, assets of passively managed funds overtook those of actively managed funds for the first time in U.S. stock markets.
Around the globe, a similar pattern is now playing out. Easily available online investment platforms and high market volatility have created a new boom in personal investing.
Consequently, the coronavirus pandemic has ushered an era of young and curious investors, who are now looking to build their first investment portfolios with low-cost options.
Passive investing offers them just such an opportunity.
In this article, we’ll take a look at the pros and cons of active and passive investment styles, as well as which strategy fits each style the best. Here is a quick review of what we’ll cover:
- What is passive investing?
- What is active investing?
- Key differences between active and passive investing
- Examples of active and passive investing
- Takeaways: Which strategy is better?
What is passive investing?
Simply put, practitioners of passive investing are looking for long-term holdings. Passive investing strategies are thus for those investors that are in it for the long haul.
This is the opposite of day trading. Passive investors do not buy and sell stocks on a regular basis. Rather, they choose to limit the number of securities they trade in a given period.
This strategy requires a buy-and-hold mentality and makes for a lower risk and a cost-effective way for participating in the stock market.
The most common example of a passive investment is the purchase of an index fund share. Typically, one that tracks one of the major indices, such as the S&P 500, Nasdaq
By buying an index fund, you participate in the overall trajectory of corporate profits of all the companies tracked on that index through just one stock.
Nowadays, you may be more familiar with a different kind of index fund, known as an exchange-traded fund (ETF).
In 1993, State Street launched the first ETF to track the S&P 500, giving the index fund a revolutionary makeover. From then on, investors could passively participate in the investment of 500 companies on the S&P through one share.
For a long time, the most famous passive investor has been Warren Buffet, a man who has consistently bet his reputation — and wealth — on the success of passive investment thinking. Today, he is one of the world’s richest people, with an estimated net worth of $71 billion in 2020.
Buffet’s aversion to actively managed funds has partially to do with their higher costs — it takes expensive fund managers to constantly pick stocks for these funds.
Successful passive investors like Buffet have one core thing in common. They all learn to keep a disciplined, long-term vision of the market, preferring to “hold” even when the market dips.
What is active investing?
As the name implies, active investing is a hands-on approach strategy. Practitioners of active investing readily try to “beat the market” by buying and trading often, based on daily fundamental company research, historical earnings and industry analyses.
Therefore, actively managed funds require a large staff of financial and industry analysts, which spend their day on phone calls to experts, reading news and diving through quantitative analyses.
Hiring this workforce costs a lot of money, which is why actively managed investment instruments are more expensive than their passively managed counterparts.
A typical example of an actively managed fund is a hedge fund. Above all, the portfolio managers that oversee these organizations must instill confidence in their ability to “read the market.”
In essence, actively managed funds aim to take advantage of short-term price fluctuations to outperform the market. By overseeing an expert team of analysts, they compile strategies that allow them to peer into the crystal ball of the future and make higher-risk, higher-reward decisions.
Key differences between active and passive investment strategies
Active and passive investing have one big difference: cost.
Active investment funds come with a much higher fee, due to the team of analysts needed to actively buy and sell stocks. Ultimately, most clients incur trading fees when they actively trade.
Passive investment funds are considered very low cost. Since there is no team of analysts looking for stock picks or overhead needed to employ them, there is only a small fee associated with buying these funds.
Put simply, passive funds just follow a certain index, allowing investors to piggyback on a secure trajectory. The ease of this product allows for reduced fees.
Proponents of passive investing, such as the famous Warren Buffet, are likely to denounce active investing because of these additional charges. To passive investors, you are losing possible returns by paying for the work done by the portfolio managers at actively managed funds.
As recently as 2016, Warren Buffet said this about passive investing: “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
The ability to invest in diversified holdings makes a large difference between active and passive investment styles.
In general, actively invested funds hold fewer stocks (or other securities) compared to index funds. For example, actively traded mutual funds may have as few as 10 holdings, with some going up to 60.
In comparison, it is very rare to find an index fund that has fewer than 50 holdings; some of them even have more than 2,000.
By virtue of the quantity of shares tracked through one stock of an index fund, investors benefit from more diversification which leads to the enhanced ability to manage risk.
Passive and active investments also differ by the level of transparency they offer.
It is always clear what the holdings are in an index fund. In particular, ETFs must disclose their prospectus of holdings to all shareholders. These can be very long and complex documents. But there is never any doubt to the investor about what they are buying.
Active funds prize flexibility more than transparency. For example, a hedge fund manager of an actively traded fund will have the ability to change his funds’ holdings at a moment’s notice.
This ability is paramount to making quick decisions to purchase shares that might be the next big profit maker.
Active and passive investment products are subject to different taxation rules.
In general, passive investment funds have a tax advantage in most countries around the world. ETFs in particular have a large tax benefit. This is because the trading of ETFs does not trigger a tax event for the buyer (although profits are still taxed). Instead, the manager of the fund is the one who has a tax liability.
For actively managed funds, the reverse is true. Here, you have a high likelihood of large capital gains taxes.
The active investor approach typically requires a good tax advisor to help navigate taxation issues while managing your portfolio to maximize profits.
Examples of active and passive investment approaches
Now that you have a grasp of their main differences, let’s look a bit deeper into what investment products are defined as either passive or active investing.
Passive investing can take several forms, including:
- Index funds that track many companies across a given stock market index. This can include some mutual funds.
- ETFs such as the VOO fund, which is managed by Vanguard and tracks the S&P 500. The majority of ETFs are considered passively managed funds.
- Robo advisors like Sarwa, which act as investment platforms and financial advisors for clients. Typically, robo advisors utilize ETFs to better manage risk for clients depending on the risk level determined by the customer and a financial counselor.
Active investing is followed across many different kinds of instruments, including:
- Hedge funds, whereby a portfolio manager actively tries to outplay the market
- Mutual funds created with the objective to outperform index funds
- Pension funds, although a fair share of their capital allocation can also go into passively managed instruments
- Day traders, such as individual traders that actively buy and sell on the market
- Wealth managers, who are hired by individuals to manage a certain portfolio with the capital invested by a client
Takeaways: Which strategy is better?
At Sarwa, we advise our customers to strongly consider the amount of risk they want for their investments before activating an investment plan.
The effectiveness of active trading is controversial at best. Theoretically, to do this well, you have to “know more than the market”. Academic research has a lot to say about this. Retail investors trade badly in several ways:
- Typically trade too much and accrue substantial transaction costs.
- The stocks they sell outperform those they buy – referred to as the “disposition effect”
- They also trade on the basis of stale news
Lots of literature exists to prove the underperformance of actively traded mutual funds as a group. Very few actively traded funds beat a passive index and, among those that do, most were luck-based.
Research shows that the passive approach has more benefits for retail investors. Importantly, passive investing does not mean “low reward.” Even within the large and growing world of ETFs, there are plenty of high-reward products being created by passive investors. Ultimately, it depends on the individuals appetite for risk and reward.
Here are some clear takeaways of why passive investing strategies will stand up against the test of time:
Low-cost: Compared with the ultra-high fees of actively managed funds, passively managed strategies are much cheaper. Follow Warren Buffet’s advice: Don’t pay someone else with your profits.
Low-risk: The actively managed approach brings with it a much larger level of risk. When managed well, the fund can produce high rewards; if not, it can be disastrous. With ETFs, there are still plenty of options to get high-reward with not as much risk.
High transparency: With index funds like ETFs, the fund managers have a legal liability to publish all the holdings within the fund. With actively managed funds like mutual funds and private hedge funds this is often not the case.
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