Breaking down the importance of active and passive investing strategies in day-to-day finance
Understanding which of the two forms of investing would benefit your finances the most
As an investor, be a newbie or not, you would have often heard to always keep track of what you own and to take stock of your assets.
If you are just starting out in your investment journey – like with anything new – what you would first need is a strategy on how to go about it.
Another such advice would be to learn as much as you can about passive and active investing – basic but simple investment strategies we explore in depth here.
If you are just starting out in your investment journey – like with anything new – what you would first need is a strategy on how to go about it.
Passive investing and active management are polar opposites.
If you’re involved in this debate, there’s really no perfect answer as to whether either of these strategies is intrinsically better. Instead, each investor’s individual circumstances will shed light on which is the more beneficial choice for them.
Active investors purchase investments and continuously monitor their activity to exploit profitable conditions.
On the other hand, passive investing broadly refers to a buy-and-hold portfolio strategy for long-term investment horizons, with minimal trading in the market.
Index investing is perhaps the most common form of passive investing, whereby investors seek to replicate and hold a broad market index or indices.
While active investors prefer consistent trading in line with market trends, in contrast, passive investors ride the market for years at a time.
Now that we have got a rough idea of the two, let’s now break each of them down and analyze which one would benefit you the most.
Break down of active investing
Active investing is highly involved.
Unlike passive investors, who invest in a stock when they believe in its potential for long-term appreciation, active investors typically look at the price movements of their stocks many times a day. And most of the time, active investors are seeking short-term profits.
For example, during the height of the 2008 financial crisis, investment managers could have adjusted portfolio exposure to the financial sector to reduce their clients’ risk in the market.
Active investing allows money managers to meet the specific needs of their clients, such as providing diversification, retirement income or a targeted investment return.
In doing so, a manager chooses from several investing strategies to ensure the goal is met, which cannot then be compared to a benchmark.
Investors can use active investing to take advantage of short-term trading opportunities. Traders can use swing trading strategies to trade market ranges or take advantage of the momentum.
Stock prices oscillate for the majority of the time which creates many short-term trading opportunities.
Investors can use active investing to take advantage of short-term trading opportunities.
Risks associated with active investing
Active investing can be costly due to the potential for numerous transactions. If an investor is continually buying and selling stocks, commissions may significantly impact the overall investment return.
Active management fees can range from 0.1 per cent to over 2 per cent of assets under management (AUM).
Active money managers may also charge a performance fee between 10 per cent and 20 per cent of the profit they generate.
Active funds also often set minimum investment thresholds for prospective investors. For example, a hedge fund might require new investors to make a starting investment of $250,000 (Dh918,262).
Break down of passive investing
Passive investing's goal is to build wealth gradually.
Passive investing methods seek to avoid the fees and limited performance that may occur with frequent trading. Also known as a buy-and-hold strategy, passive investing means buying a security to own it long-term.
Passive investing methods seek to avoid the fees and limited performance that may occur with frequent trading.
Passive investing is, as touched upon earlier, the better investment option among the two strategies for most individuals. That, of course, doesn't mean it will yield the best returns.
On the contrary, it means when other investing unknowns are taken into consideration, it's currently the most reliable method to yield the most stable results.
It is an investment choice that costs below 1 per cent annually to own. Without having a manager to make frequent changes, the middle-man expense is cut off.
In short, this means you’ll lose less of your returns to management.
ETFs and mutual funds are staples of passive investing portfolios. They all also have a couple characteristics in common: professional management and inherent diversification.
When you invest in stocks, bonds or any other security on a singular basis, it’s up to you to choose which ones you want and when to buy and sell them.
ETFs and mutual funds are staples of passive investing portfolios.
But because investment professionals manage the aforementioned trio of funds, you’ll reap the rewards of strong diversification and asset allocations without getting your hands dirty.
Good asset allocation is proven to affect returns more than anything else.
You do this by not putting all of your eggs in one basket and diversifying. Using mutual funds or ETFs that accurately track an index you are investing in you are investing in the entire market.
By not using actively managed funds for most investment choices, you are not actively trading. This not only means less effort, it also means less prone to short-term fluctuations.
So while the overall performance of these funds dictates your eventual returns, the investment decisions are not under your control.
Thus, this lack of customization and flexibility could leave passive investors feeling like they’re not involved enough in the overall management of their money.
However risky as it may be, passive investing technically has less return upside than strategies that look to beat the market through stock-picking and recurring trades.
In return for this trade-off, though, passive investors regularly see slow and sustained growth.
So, go passive or actively invest?
What this decision ultimately comes down to is your risk tolerance, which is your ability to stomach volatility in the hopes of higher returns.
If risky investing is within your means, an active portfolio could be more fitting.
While no equity-focused investment approach can be called safe, a portfolio more focused on matching market returns is safer than one seeking to “beat” or “time” the market.
On the other hand, if risky investing is within your means, an active portfolio could be more fitting.
For example, let’s say there’s a 25-year-old who wants to buy a home over the next few years and a 30-year-old who’s saving for retirement. The investments they should make are drastically different.
Because the future homeowner is closing in on his or her goal, he or she might consider high-risk, high-reward investments.
Retirement is far away for the 30-year-old, though, allowing this person to stick to passive investing if he or she so chooses.
If you want an actively-managed portfolio, know that you will encounter more fees than a passive investor will.
Because active management calls for consistent trades to beat the market, you’ll likely spend a significant amount in transaction fees. Passive investors prefer to buy and hold securities, lowering their extraneous costs in the process.
Although passive investing has comparatively more perks, that doesn’t mean it’s the right strategy for everyone.
But keep in mind, before investing any money in the market, you should take some time to learn about the strategies that will suit you best.
So although passive investing has comparatively more perks, that doesn’t mean it’s the right strategy for everyone.
Especially in an uncertain economy, active funds will perform better than the broad market.
The logic is simply that a basket of stronger companies, cherry-picked by fund managers, is likely to perform better than the broader markets, irrespective of the economy.
If you consider any relevant market’s inefficiency, there are a lot of opportunities here that can be capitalized upon by active managers.
Most good-quality actively-managed funds have a standard deviation lower than that of their benchmark index.
While delivering higher returns, experts believe active fund managers can also offer lower volatility.
Contrary to popular perception, market volatility can be a blessing for the active fund manager by throwing up opportunities to pick quality stocks at attractive valuations.
Many businesses that appear over-priced at one point will be available at very attractive valuations at another.
A market’s short-term over-reaction also creates a margin of safety.
Suppose the value of a company gets eroded by 10 per cent, but if the fall in its stock price is 30 per cent, the fund manager entering it enjoys a 20-percentage point margin of safety. Bigger the margin of safety, safer the investor is.
According to the latest ‘S&P Indices Versus Active’ report, many categories of active funds are, on an average, underperforming their benchmarks even over the long-term.
While passive funds can’t give you market-beating returns, they don’t underperform either (or do so only by a small margin, called the tracking error).
Moreover, while a small proportion of active fund managers will always beat their benchmarks, predicting in advance who among the hundreds operating in the mutual fund universe will do so is a very difficult task.
A fund manager who was a top performer over the past five years may not remain so over the next five years.
Also, returns of active fund managers tend to oscillate. A fund manager who was a top performer over the past five years may not remain so over the next five years.
Moreover, the index is created by independent index providers using transparent rules. There’s no fund manager bias in indexing, as happens in active investing. It also comes with advantages like low cost and diversification.