The debate between active and passive investing is an ongoing one, which can very often lead to heated investment debates, with many wealth managers tending to favour one strategy over the other. The reality, however, is that each investment style has its own distinct advantages and disadvantages, which should be considered on their merits while giving due consideration to both costs and risk. Depending on your particular investment objectives, you may find that there is room in your portfolio for both strategies.
Let’s examine the difference between these two styles of investing.
Passive investors limit the amount of buying and selling within their portfolios, making this a very cost-effective way to invest. The strategy requires a buy-and-hold mentality, with little room for emotional response to changing market conditions. Passive funds are limited to a specific index with little or no room for variance, which means that investors remain invested in those holdings regardless of market turmoil. As a result, passive investors can avoid succumbing to the investor biases that often plague active investors.
However, various index funds give exposure to a full range of assets, which means that you will still need to implement some sort of stock-picking strategy, bearing in mind that indexing works well when you have broad exposure to an asset class or the market.
Passive investors can have very different returns depending on which index, asset, share or market they are tracking. Because of the lower investment fees, passive investing can be an excellent way to gain market exposure, particularly in more efficient markets.
In terms of disadvantages, it is important to remember that passive investing means you can never out-perform the index and, as an investor, you will only get what the market returns.
On the other hand, active investing takes a hands-on approach and requires that someone performs the role of portfolio manager. By its nature, active investing is designed to beat the stock market’s average returns and to take advantage of short-term price fluctuations. Effective portfolio managers require in-depth knowledge and expertise in order to know when to move in or out of a particular asset – with good portfolio managers being able to make the correct investment decisions more often than not.
With the benefit of extensive research and astute investment judgement, a portfolio manager’s job is to create a portfolio that will outperform a benchmark over a pre-determined period of time. This style of investing allows the portfolio manager to make investment decisions based on a set investment mandate, allowing them autonomy to change underlying shares and asset allocation in order to meet their objectives. With the right active fund manager, together with competitive fees, significant value can be added to your investment portfolio over time through this type of strategy.
Many investors find the flexibility and freedom of choice in an actively-managed strategy attractive, particularly the ability to exclude assets that conflict with their moral or ethical beliefs.
It is important to remember that, because active investing involves greater rewards, there is also a greater level of investment risk. Further, investment fees are generally higher due to the larger number of transactions and the costs of the expert portfolio management team.
In essence, the purpose of passive investing is to simply track an index so that the investor can achieve the market average; whereas the function of active investing is to try to outperform a pre-determined benchmark over time. Regardless of the disparity between these two investment styles, these two strategies are not mutually exclusive and there can be room in your portfolio to use both active- and passive investing.