Active vs passive investing: which is right for me?

Capital at risk. The value of your investments can go up and down, and you may get back less than you invest.

What’s the best way to invest? Spending your time flicking through earnings reports trying to find a gem of a company that no-one has seen yet? Or how about automating a monthly payment into a fund that represents every stock in an index?

It’s a debate that keeps raging in the investment world, so it’s worth digging into exactly what we mean on both sides. Bear in mind, though, that while inkwells have run dry weighing up the pros and cons of active and passive investing, as an investor you don’t need to fully sit in either camp. So, let’s explore what the big differences are and how you can get a sense of which works best for you.

When you do your own research into stocks and put your money into them you become an active investor. That decision-making process and the whittling down of investment opportunities to the select few you think are good ideas sets this approach apart from broadly spreading your money over a range of assets in an index.

You might be the active investor here or you might outsource that responsibility to a fund manager by investing in their fund. They and their team of analysts will do the job for you in the pursuit of investment returns above what the general market delivers. They choose the assets, when to buy and sell them and give you a chance to make use of their experience and market nous. Even though you pay for this service, beating the market isn’t a sure thing though, which means there are lots of opinions on whether it’s worth it or not.

The reality is that, in this instance, you pay for the approach the fund manager brings to investing. They might focus on a specific country or a style like trying to unearth hidden stock market winners. They won’t always be successful but if it’s an approach you like and just don’t have the time, expertise or motivation to do yourself, they’re there to do it for you.

Just remember that even the pros can’t tell the future so it’s important to understand how they make their returns, not just what the returns are. Sooner or later you’ll ask yourself why a certain fund has gone through a bad patch and knowing what they’ve been doing all along will be key.

It also helps you figure out if you really want their approach, given the state of the world and other market influences. Big growth companies shone in the decade after the financial crisis - knowing which managers tapped into them and which didn’t would have been a critical comparison to make.

Types of active investment products

• Open-ended investment companies (OEICs) with a human at the helm
• Closed-ended investment trusts/investment companies
• Real estate investment companies (REITs)
• Unit trusts (UTs) managed by people
• Active exchange-traded funds (ETFs)
• Hedge funds

Back in 1974, a seemingly exasperated Nobel Laureate economist Paul Samuelson asked for “some large foundation to set up an in-house portfolio that tracks the S&P 500 Index - if only for the purpose of setting up a naïve model against which their in-house gunslingers can measure their prowess…'

The point here was to give active investors a way to invest in the index and to measure their stock-picking abilities and, crucially, those of the people employed to invest on their behalf. Two years later, Jack Bogle, the founder of Vanguard, introduced the first fund designed to mimic the performance of an index. This gave investors the option to either invest in stocks directly, pay someone to invest for them, or invest in the average performance of the index itself.

Fast forward and open-ended index funds, and more recently exchange-traded funds (ETFs), have become the go-to for investors looking to replicate the broader market in their portfolios. Once the portfolio is set up to track the performance of the index, the humans step back and let the ‘passive’ part do its thing. It’s why you’ll often see a lower price tag on passive funds - no teams of analysts trying to beat the market means lower costs for the investor.

Types of passive investment products

• OEICs managed passively
• UTs managed passively
• Smart beta ETFs
• Index ETFs

On 1 January 2008, Warren Buffett famously put his money where his mouth is and bet that the S&P 500 would outperform the average return of five hedge funds chosen over the subsequent 10 years. He won and around $2.2m was donated to charity.

The takeaway was that the index can be as useful an investment as any and taking high risk and paying huge fees for the privilege is no guarantee of outperformance.

It’s an extreme example and it’s true that consistent outperformance from active funds is hard to come by but that might be missing the point. If you know how an active fund manager approaches the market you can see where their weak points might be, you can decide if you want them in your portfolio and think about which other funds could complement them. Like players in a team, they should be able to rise to the occasion and perform differently to each other in distinct market conditions. In this sense, it’s not about comparing one active approach to the index but your overall collection of funds to a passive approach.

Essentially, ask what an active manager is giving you that a passive version costing less doesn’t. It may be nothing, or it may be exactly what you’re looking for.

So, do you want market performance minus smaller fees or the opportunity to beat the market (with no guarantee), often with higher fees? That’s really what it comes down to.

Look out for the Frankensteins of the active and passive world. It’s becoming harder to distinguish which is which as some have body parts from both.

Smart beta ETFs have more rules to follow than a general index ETF and will normally track an index that has been designed to deliver a specific outcome, like income or low volatility. They might be set up to only follow a rule, or ‘factor’, like company quality, meaning the ETF only holds companies with strong balance sheets, stable cash flows and superior profits. The point here is there’s an active element in there that sets this style apart from vanilla index ETFs.

Active ETFs blur the lines by having a portfolio manager, who adjusts the investments within the fund with the aim of beating a certain benchmark. Isn’t that just what an active mutual fund does, though? Pretty much, though active ETFs are priced throughout the day like a stock, rather than having just one dealing price, tend to be cheaper and show their entire holdings rather than just the top 10, as is usual in the mutual fund world.

There is often an idea that different strategies suit different markets better. A common example here suggests the US market is so well researched that the majority of available stock-sensitive information is baked into share prices, meaning that outperforming the index is difficult. The idea is that passive strategies may be the most appropriate here, although a lot of US individual equity investors and fund managers may disagree.

The opposite is often said of smaller companies or emerging markets, where research can be thin on the ground, presenting the opportunity for mispricing, which investors can take advantage of through an active approach. Investing passively here, so the thought goes, gives investors exposure to the winners as well as the laggards - where the quality gap is wider than in other, well-researched markets.

The good thing is we don’t need to hitch our wagon to either side. Instead, think about how you might use a mix of strategies to ensure your holdings are globally diversified, with a range of approaches like value and growth, with all sizes of company represented, and making sure you aren’t paying for what you don’t want or need.

Sometimes this leads investors to use a core and satellite approach, with major index ETFs surrounded by smaller active positions. This gives broad exposure to the index, supplemented by some stock or active fund ideas you might have.

Just remember that index products like ETFs don’t necessarily offer the diversification you might expect. While an S&P 500 ETF is diversified across US stocks, if the US experiences an unexpected market event, chances are all those stocks will feel it. The same goes for active ETFs focusing on specific sectors, like clean energy. While you are more diversified here than investing in one clean energy company, an industry-specific effect is likely to influence the majority of stocks in the ETF.

1. If you are investing in an active fund, you’re paying for a professional fund manager to deliver different performance to the benchmark. But, if their fund looks just like the index, what are you paying them for? That’s why it’s a good idea to check the fund’s ‘active share’, which measures how different a fund is to the index. A high active share tends to start at 60% and the higher it goes, the more different the fund will be. The last thing you want is an index-tracker masquerading as an active fund and charging higher fees for no real benefit.
2. If you are investing in a passive fund, the aim is for it to track its underlying index, like the S&P 500. A good way to see if it is doing this well or not is by looking at the tracking error. This lets you see how good the fund is at mimicking the index - a lower number is better and is usually only around a few tenths of a percentage point.
3. Check the company weightings in passive funds. Most passive funds are market cap-weighted, meaning the world’s biggest companies already occupy a hefty chunk of the portfolio. Once you see how much of a company you’re exposed to just by buying a passive fund, it may help you decide how much to allocate to any other companies, possibly in a core and satellite approach.
4. Keep an eye on fees and focus on value, not headline price. As we’ve said, passive funds often carry a lower price tag as there’s less research going on in the background. If you find an active fund that’s comparatively more expensive but suits your aims better and is delivering on them, it might be worth paying up for. In the end, it’s about the value you get, not a race to the bottom in terms of cost. Also don’t assume ETFs are always cheaper than active funds, especially when it comes to sector ETFs. That extra bit of active management involved here can raise the price, so always check.
5. Whatever strategy you’re thinking of buying into, think about the approach being used and whether it’s sustainable or not. There has been a wave of new ETFs focusing on strategies from pet care to unhealthy habits to K-POP. Time will tell whether they’re a success or not but often these launches feel opportunistic. Remember to situate the strategies in terms of your long-term investing journey instead of what’s popular now.
6. Holding too many active funds? You might be inadvertently recreating the index and paying up for the privilege. ‘Diworsification’ can also be a problem if you’re racking up funds with the same holdings, meaning you’re actually concentrating your exposure to certain stocks instead of spreading your risk. It’s tempting to keep adding funds as you come across them but discipline is important. As legendary investor Peter Lynch said, “Know what you own and know why you own it.”

Source:

• Samuelson, Paul A. Challenge to judgment, Vol. 1, No.1, p.18, The Journal of Portfolio Management, 1974.

Important information

When you invest your capital is at risk. Past performance is not a reliable guide to future gains. Your investments and the income you receive from them may go down as well as up so you may get back less than you invest.

This article is intended for educational purposes only. Make sure to do your own research on what investments are right for you before investing or consider seeking expert advice.

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