Active vs passive investing

There is an ongoing debate as to which of the two investing approaches, active and passive, are more effective. Passive investing has increased in popularity in recent years, with assets in exchange-traded funds (ETFs) and index funds surpassing assets in actively-managed funds for the first time in history in 2019. In this article, we seek to clarify the differences between active and passive investing, and examine the pros and cons of each style of investing.

What is active investing?

Active investing is a strategy that involves actively buying and selling securities for a fund. In this style of investing, investment managers assess a wide range of securities and choose which ones to buy and sell, with the goal of outperforming an index (or generating ‘alpha’ as the professionals describe it), such as the Morningstar Global Equity Index.

With actively-managed funds, fund managers make decisions on what to invest in based on their research and views. Managers will invest in a blend of assets, in line with the objectives of the fund, adjusting the weighting of shares, bonds, and alternatives to manage risk. In the long run, the asset allocation will be managed in line with the fund’s ‘strategic’ asset allocation. However, in the short term, the fund manager may make minor adjustments in an effort to take advantage of attractive investment opportunities. These short-term adjustments are known as a ‘tactical’ asset allocation. Fund managers will stay up-to-date with the latest market trends, news related to the global economy, and any other events that could affect the performance of the investments in the fund.

Those who invest on an active basis believe that they can achieve greater performance than those who are simply tracking an index or market.

What is passive investing?

Passive investing can be referred to as index fund management. Here, the managers of a fund aim to just match the returns of a specific market index or benchmark. They do this by owning the exact same investments that are in the chosen index. With passive funds, fund managers do not actively assess investments and make decisions in relation to what securities to buy and sell.

Active vs passive investing: which is right for you?

To assess which investment style is right for you, here is a summary of the pros and cons associated with active and passive investing.

The pros and cons of active investing

The main advantage of active investing is that it enables fund managers to take advantage of attractive investment opportunities. For example, if a sector or stock appears undervalued, the investor can seek to capitalise. This means that there is the potential to outperform the benchmark or index.

Another advantage of active investing is that it gives investors more control and flexibility. For instance, if a fund manager wants to avoid a particular sector or stock for ethical reasons, they can.

It’s also possible for active managers to use hedging strategies. This is a form of risk management whereby the investor takes an offset position through shorting or options. Hedging can help minimise the probability of a big loss.

On the downside, one of the drawbacks of active investing is that fees are generally higher than passive investment fees. This is due to the costs of research and active trading. And of course, if a manager can outperform their passive counterparts, they can also underperform just as much.

The pros and cons of passive investing

One key advantage of passive investing is that fees are generally lower than active investment fees due to the fact that there is less human oversight required.

The simplicity of passive investments is another benefit. Investors often feel more comfortable with passive funds because they know exactly what they’re getting – an investment that follows the market index.

Many investors also like the fact that there is a higher level of transparency associated with index funds as it is always clear what assets are held and this is refreshed daily.  

On the downside, there is less potential for higher returns with passive funds. By definition, a passive fund will never beat the market. Your investment is also at the mercy of the market, with no active downside protection should there be a downturn.

Active vs passive investing: a combination of both?

As for which investment style is more suitable, a robust investment strategy can encompass both active and passive investing styles. When markets are volatile, investors may benefit from an active style of management, as fund managers might be able to minimise losses. However, there are also instances in which passive funds could potentially outperform active funds and you’d also be saving on the generally higher costs associated with active investing.

An investment plan should always start with your financial objectives and your attitude towards risk. This is where a financial adviser can add value as they will be able to develop an investment plan that is tailored to your individual requirements.

To find out more, or if you have any questions in relation to investment advice, don’t hesitate to request a callback.

Remember, your investments may go down as well as up and you could get back less than you originally invested.