Passive Investing vs. Active Investing

6 mins read

Any discussion on the difference between active and passive investing may rapidly devolve into a heated disagreement, as investors and wealth managers frequently favour one technique over the other. While passive investment is more popular with investors, there are compelling reasons for the advantages of active investing.

Active and passive investment:

Active Investing

As the name implies, active investing is a hands-on process that requires someone to operate in the capacity of a portfolio manager. Active money management seeks to outperform the stock market’s average returns and capitalise on short-term price swings. It requires a more in-depth examination and the skill to determine when to enter or exit a particular stock, bond, or another asset. Typically, a portfolio manager supervises a team of analysts that analyse qualitative and quantitative aspects and then peer into their crystal balls to forecast where and when the price will change.

Active investing necessitates trust that whoever manages the portfolio will know precisely when to buy or sell. Active investment management success needs to be correct more frequently than not.

Passive Investing

If you’re a long-term investor, you’re a passive investor. Passive investors minimise their portfolio’s purchasing and selling, making this a particularly cost-effective approach to invest. The technique necessitates a buy-and-hold attitude, which entails restraining oneself from reacting to or anticipating the stock market’s every move.

A passive method is best illustrated by purchasing an index fund that tracks one of the major benchmarks, like the S&P 500 or Dow Jones Industrial Average (DJIA). When these indices rebalance their members, the index funds that track them automatically rebalance their holdings by selling the stock that is leaving the index and purchasing the joining stock. This is why it is such a significant milestone when a company achieves the size necessary to be included in a major index. It ensures that the stock will become a core investment in tens of thousands of large mutual funds.

When you hold small fractions of thousands of stocks, you make returns simply by participating in the broader stock market’s rising trend of company earnings over time. Successful passive investors maintain a long-term perspective and disregard short-term setbacks—even severe downturns.

Advantages of Passive Investing

Several of the primary advantages of passive investing include the following:

Fees are meagre: Because no one is picking stocks, supervision is significantly less expensive. Passive funds merely track the index against which they are benchmarked.

Transparency:

An index fund’s holdings are always transparent.

Efficient taxation:

Their buy-and-hold strategy often does not result in a colossal capital gains tax liability for the year.

Disadvantages of Passive Investing

Active investors would argue that passive solutions have the following flaws:

Too constrained:

Passive funds are constrained to a single index or fixed set of investments with little to no variation; as a result, investors are locked into those holdings regardless of market conditions.

Small returns:

Passive funds, by design, will rarely outperform the market, even during periods of market turbulence, because their fundamental assets are locked in to track the market. While a passive fund may occasionally outperform the market, it will never achieve the significant returns sought by active managers until the market itself booms. Active managers, on the other hand, can generate better returns (see below). However, those returns come at a higher risk.

Advantages of Active Investing

According to Wharton, the following are the advantages of active investing:

Flexibility:

Active managers are not obligated to track a particular index, and they might purchase the stocks they think to be “diamonds in the rough.”

Active managers can also hedge their bets through various strategies such as short sales or put options, and they can abandon certain companies or sectors when the risks become too high. Passive managers are obligated to keep the stocks that the index they monitor, regardless of their performance.

While this method may trigger capital gains tax, advisors can customise tax management tactics to individual clients, such as selling underperforming investments to offset the taxes on the big winners.

Disadvantages of Active Investing

However, dynamic tactics have the following drawbacks:

Extremely costly:

According to Thomson Reuters Lipper, the average expense ratio for an actively managed equities fund is 1.4 per cent, compared to 0.6 per cent for an average passive stock fund. Fees are more significant because all of the active buying and selling results in transaction fees, not to mention the salary of the analyst team responsible for analysing equity picks. All of those expenses accumulate over decades of investing and can significantly reduce profits.

Operational risk:

Active managers can invest in whatever they believe will generate high returns, which is excellent when the analysts are correct but disastrous when they are incorrect.

Particular Considerations

Which of these tactics then generates the most significant profit for investors? You’d assume the talents of a skilled money manager would exceed those of a simple index fund, and however, they do not. Passive investment superficially appears to be the most excellent option for the majority of investors. Study after study (spanning decades) demonstrates that active managers do poorly.

Only a small percentage of actively managed mutual funds have ever outperformed passive index funds.

All of this information demonstrates that passive beats Active investment; on the other hand, it may be oversimplifying something far more complex, as active and passive investing are two sides of the same coin. Both exist for a reason, and many professionals combine the two.

The hedge fund sector is an excellent illustration. Managers of hedge funds are renowned for their extreme sensitivity to even the most minor changes in asset prices. Typically, hedge funds avoid popular investments, but according to research firm Symmetric, these same hedge fund managers invested about $50 billion in index funds in 2017. Only $12 billion in passive funds were held by hedge funds ten years ago. Even the most aggressive active asset managers choose passive investments for a variety of reasons.

However, data indicate that actively managed Exchange-Traded Funds (ETFs) did well amid market upheavals, such as the end of 2019. While passive funds continue to dominate generally due to their cheaper costs, investors are shown to accept higher fees for an active manager’s skill to lead them through all the volatility or extreme market price fluctuations.