Active versus Passive Investing – A Quick Guide

The “active versus passive investing” debate is one of the longest running in investment management and there is a lot to be said on both sides. Investors certainly do not have to make a binary choice between the two investment styles, however, since most wealth managers offer both options, yet some investment houses do favour one approach over the other. Indeed, you yourself may be inclined to weight your portfolio more towards either passive or active investments depending on your views and investment objectives.

How it works

Active investors work in the belief that markets are inefficient. They believe human fallibility leads to assets being mis-priced and that profits are to be had by buying or selling assets to take advantage of these inefficiencies.

For example, if a big petrochemical company became embroiled in an environmental scandal the markets could react by pricing in trouble for the whole sector – despite the fundamentals of the sector as a whole and the other individual companies within it being sound. An active, value-focused investor could therefore take this as an opportunity to buy undervalued stock in companies which had been irrationally downgraded in the mind of the marketplace.

In contrast to proponents of active investing, passive investors work on the assumption that markets are eventually efficient, meaning that while asset prices might fluctuate in the short term, over the long term their true underlying value is accurately reflected. With this in mind, proponents of passive investing believe that trying to beat the market is folly. Basically, their view is that while there might be some opportunities to make profits by timing the markets better than anyone else, actually achieving this is a hit and miss affair. Furthermore, they might argue that the additional transaction costs associated with regularly “churning” the constituent holdings within a portfolio is likely to cancel out any gains made by insightful investment calls.

Rather than attempting to time the markets, those favouring a passive investment style instead try to replicate the performance of a certain market by buying investments which mimic the market, such as index tracker funds and Exchange-Traded Funds.

One analogy which can be used to illustrate the difference between passive and active investing styles is that of two cars trying to get to the same destination. One (representing active investing) is a sports car speeding and weaving in and out of traffic to try to fit into gaps as they appear and get to the finish line first; the other is a more sedate saloon car which sticks to the speed limit and focuses on keeping pace with the rest of the traffic (i.e. the market). To extend this analogy a little further, the (passive) saloon probably won’t make record time, but nor is it likely to crash at high speed; meanwhile, the (active) sports car provides all the thrills (and potential spills) of high-speed racing and the potential for greater glory. Needless to say, winning the race for investment returns also requires a highly-skilled driver with steady nerves, fast reactions and excellent insight into how the road ahead lies.

A question of philosophy

To an extent, the choice between a predominantly active or passive investment approach is a question of philosophy. However, your choice will also be dictated by your investment objectives and time horizons, your risk and return parameters and how much you are willing to pay in investment management, performance and fund fees. When looking at funds, you will find that passive vehicles are broadly a lower-cost option since they are less maintenance in terms of monitoring and managing the underlying investments, but also because far fewer transaction costs are incurred compared to active investing, where assets are bought and sold continually.

That said, a highly-skilled investment manager can seek ambitious returns which could more than offset any premium which you pay for going down the actively-managed route; they might also be better placed to take defensive action against adverse market conditions. You need to carefully weigh up the total costs of owning an investment, which is indicated by its Total Expense Ratio figure, against the likely returns that it will generate, less performance fees where applicable. The credentials and track record of the manager or team running the fund will also help inform your decision, although – as we all know – past performance is no guarantee of future returns.

Passive investment funds like ETFs can form a very useful part of your investment portfolio, since they offer low cost access to virtually any market or sector, without the costs and complications of buying individual assets (there may be tax advantages in passive investing, for example). You may also find that passive vehicles are more appealing from a risk perspective. However, passive investments are not without their downsides either. There are thousands of ETFs on the market and they vary hugely as to their performance track records and future prospects. Your wealth manager will be able to advise you on solid investment vehicles in whichever style of management you prefer.

While there are certainly passionate advocates on both sides of the active versus passive investing debate, arguably this division is now really redundant as wealth manager can use a sophisticated mixture of investment styles where it is warranted. You will often find wealth managers today advocating what is known as a smart beta approach. This denotes an investment style where the fund manager follows or tracks a market index, but only partially. Rather than weighting the constituents in a fund in line with traditional market cap weightings, proponents of smart beta would weight a fund’s make-up according to the volatility levels of the underlying assets (or another variable). Traditional passive strategies might lead to the fund being “overweight” overvalued stocks and “underweight” undervalued stocks – which, of course, is no way to maximise returns. Smart beta strategies are the next evolution on from pure passives and are certainly something you might like to discuss with your wealth manager.

While there are some complex arguments around the type of funds you should deploy in your investment portfolio (and also a lot of choice on offer) you should remember that you don’t necessarily have to concern yourself with fund selection at all. Wealth managers are in the business of picking funds with good prospects and indeed many run investment funds very successfully internally. How much involvement you wish to have in the construction your investment portfolio is entirely you choice and you may wish to become more – or less – hands on as your relationship with your wealth manager develops. The institutions on the panel offer services to suit all preferences, and you can quickly and easily start the process of finding your perfect match by trying our smart online tool. Or, if you would like to discuss your situation with our straight-talking team, please do get in touch here.

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