One of the more interesting topics on the market has been which investment style generates the best market return over time. You may not be interested in any debates or taking sides (after all you care about your portfolio and how it performs). It is however important to understand where these styles differ, what the underlying philosophies are and what style you may prefer as an investor.
We have covered active investing here and passive investing here in some detail and in those articles we covered the advantages of one style with examples of active and passive investing.
Starting with those articles let us consider passive and active investment and how they compare.
Active Investing
An active investment strategy aims to outperform the market index or benchmark by applying information gained from research, analyse the market to find opportunities such stock that are thought to be undervalued and selling any underperforming positions in the funds.
The active fund managers will carry out this research and execute the orders and you can find our article on this topic here.
Passive Investing
The goal of a passive investment strategy is to closely match the return of an index or benchmark and as a result, a fund manager is not required to manage the buying or selling of securities. You can read more in-depth details here regarding what a Passive Investing is and how it works.
How they compare
| Active Investing | Passive Investing | |
| Believes the markets are inefficient and investor behave in an irrational manner thereby creating inefficiencies that can be exploited. | Core Belief | Believes in the market is efficient and that inefficiencies are already priced in. |
| Adopts a strategy to beat the market by picking stocks that will help reach this goal. | Strategy | Aims to be get a market return through buying and holding index trackers, ETFs or other tracker funds. |
| There is little diversification in the active funds and a significant effort is put in picking the right stock. Sudden market events can lead to higher volatility and the inability to exit a position. | Risk | The passive funds are more diverse and many of them such as ETFs can be traded on an Exchange. Liquidity is less of an issue and the impact of a market volatility is less compared with an active fund. |
| Costs are higher in an active fund. Paying the manager for managing the Fund, research costs, transaction costs when entering and exiting positions in a short period of time. All these costs add up. | Costs | Costs are very low compared with an active fund and since the position is held for a longer time frame, there is less selling or buying transaction cost, no cost incurred by paying for research on the companies being tracked. |
| Many active fund managers fail to beat the market and this is a trend that has been seen for the past few years. | Performance | Passive funds with their lower costs, better diversification outperform active fund managers. |
What Style should you Adopt
As investor you will have different approaches to investing however the aim is the same; to see your investments grow, take advantage of new opportunities while keeping any associated costs low, having a good level of diversification and a good night’s rest.
Based on what has been discussed, it appears the way to go about it is to adopt a strategy that gives the best of both an active and passive investment strategy. The aim here is to benefit from the benefits of one technique whilst avoiding the disadvantages.
In a situation where there is volatility in the market due to a trade war, a Covid-19 prolonged impact on the economy, Tesla buying a large amount of Bitcoin or Reddit users taking on Wallstreet, you should find avenues to hedge your positions and minimise any downside risks.
Consider an examples where you have an ETF that tracks tech stocks – the ETF is heavily weighted towards the FAANG (Facebook, Apple, Amazon, Netflix and Google) stocks.
Now you discover through research that Netflix has seen a surge in subscribers for various reasons. Whilst you enjoy the benefits in your ETF, you can also choose to purchase shares in Netflix.
Remember this is one basic scenario and there many others where other asset classes like options or even Forex can be used to hedge, diversify and minimize the risk of loss to your positions.
Final Note
There are benefits on both side of the arguments however the data speaks for itself. The data has showing a large inflow of money into more passive funds whilst active fund and their managers have failed to beat the market in majority of the cases. Those numbers has not improved over time and there has been significant outflows from active funds.
Passive investors may be missing out on opportunities to otherwise increase their returns and rather than stick with the market performance, they could be in a position to beat the market.
Active investors on the other hand are likely to spend resources looking at the next big stock, asset class or trend and the short term prices inefficiencies are created a capitalise on them. Realising opportunities and trends requires time, effort and money and all these are costs.
As an investor it is necessary to look at the potential benefits of each strategy and apply them accordingly. In some scenarios such as investing in emerging markets, one style may be preferably for cost reasons, market transparency, etc. In other situations, some asset classes may yield opportunities to invest without too much overhead.
