As of 2019, assets managed in passive investing products have reached the same level as those managed in actively managed funds in the US. Around the world, a similar pattern is playing out as investors look to low cost investing products. In this article, we look at some of the critical differences between passive and active investing strategies and discuss if, or when, either approach is superior.
- What is active investing?
- What is passive investing?
- Key differences: Active vs. passive investing
- Examples of active investing and passive investing
- Active vs. passive: Which investment strategy is better?
- Investment industry trends
What is active investing?
Active investing simply implies a hands-on approach to decision making by a portfolio manager. The fund manager will buy and sell investments as the outlook changes for each investment – also known as stock picking. There are lots of approaches an active investor can take to making investment decisions, but in most cases, the objective is to beat the stock market. Typically, fund managers use a market index as a benchmark which they aim to outperform.
Decisions are primarily made using fundamental analysis, although quantitative techniques are used too. Often a fund manager will draw on input from a large team of analysts, each specializing in a different sector. Active investors take particular note of the value, growth, profitability, and yield characteristics of a stock. They will study the competitive environment and the market in which the company operates. They will also look at the macroeconomic factors that may affect a company.
Active investing is forward-looking with the goal being to outperform the market or produce superior risk-adjusted returns. Often the approaches used to achieve this are difficult to measure or validate using empirical evidence. The result is that the reputation of a fund or strategy is often closely linked to key individuals. Investors in active funds tend to put their faith in specific managers, rather than a process or strategy.
Actively managed funds typically come in three forms. Actively managed mutual funds are marketed to retail investors. Segregated funds are marketed to high net worth individuals and small institutions. These funds can be tailored to suit the needs of the client. Large institutions like pension funds often employ active managers to manage funds inhouse.
What is passive investing?
Passive investing strategies limit the amount of turnover in a fund by tracking an index. Occasionally other methods are used, such as using a filter to select stocks. For the most part, this is the same as buy and hold investing, though some investments are sold when indices are reweighted. Passive investing relies on the idea that as the more successful stocks in an index appreciate, their weighting in the fund will grow. Similarly, the weighting of underperforming stocks will decline, and they will have a diminishing impact on the fund’s performance.
Passively managed funds are also known as index funds. The first index funds were mutual funds, which existed as a niche product but never saw widespread adoption. However, in 1993, the first ETF (Exchange Traded Fund), which tracked the S&P 500 index was launched. This fund allowed investors to invest in all 500 companies in the index by only buying one stock.
The introduction of ETFs coincided with research showing that the majority of actively managed funds underperformed their benchmarks. The realization that investors could now invest in the benchmark for a much lower fee led to rapid growth in the passive investing industry. The initial passive approach was to create products that tracked the existing indices that were widely used as benchmarks by active managers. As the ETF investing industry grew, new indices were created for funds with distinct goals to track.
Factor investing has grown in popularity along with the passive investing industry. Thus, exchange traded funds that target growth, value, yield, and other factors are now widely available to investors. Smart-beta funds use a combination of factors to reduce volatility and generate better risk-adjusted returns.
Key differences: Active vs. passive investing
While the different approaches to stock selection are the most apparent difference between the two investment styles, the most significant difference is the fees that are charged. The management fee typically charged for a passive index fund is much lower than it is for an active fund.
Annual management fees can reduce the future value of a portfolio by a substantial amount over time. Unless an active manager can demonstrate their ability to beat the market, there is no point paying higher fees. The fees are directly related to the costs associated with managing money actively and passively. Active management requires a team of experienced (and expensive) analysts and fund managers. Index funds can be managed by a very small team.
Active investing funds tend to hold fewer stocks (or other instruments) than index funds. Active mutual funds may have as few as ten holdings, though 20 to 60 holdings are more common. By contrast, very few index funds have fewer than 50 holdings, and some have over 2,000. This makes sense as passive investing strategies are unable to manage the risk associated with concentrated portfolios.
The two investing styles have evolved in parallel with two different types of investment products. The active investing industry has evolved with the mutual fund industry, and most active strategies are made available to retail investors in the form of mutual funds. These funds allow investor funds to be pooled but are not themselves tradable. Mutual fund investments and withdrawals are made at the fund’s NAV, with fees added separately.
Passive strategies are most commonly packaged as exchange traded funds. ETFs are tradeable, and the price at which they are traded is subject to supply and demand. In reality, market makers keep the bid-offer spread close to the NAV. In the case of ETFs, the annual management fees are subtracted from the fund’s assets, rather than being charged to the investor.
The objective of active management strategies is to earn alpha or excess returns over and above a benchmark. Passive managers are only attempting to earn the market return or beta. Thus, while passive fees offer cost-effective investing, only active strategies provide any chance of outperformance.
Because active managers charge higher fees, segregated funds can be tailored to the needs of clients. Funds are often managed like this for high net worth and institutional clients. By contrast, passive products are generic and are considered tools to be used to build a portfolio. Active strategies are more commonly hedged and make use of a wider variety of instruments. Some mutual funds do use basic hedging strategies, while hedge funds make extensive use of short selling, leverage, and derivatives.
Passive investing products have inherent tax advantages in most countries. The buying and selling of stocks within an ETF do not trigger a tax event, though the eventual profit on an ETF may be taxable. An actively managed portfolio may create tax liabilities when individual securities are sold. On the other hand, actively managed portfolios can be structured to be tax efficient.
Examples of active investing and passive investing
Active investing can take many forms, including the following examples:
- Anyone actively managing their own trading account and actively picking stocks is engaged in active investing.
- Similarly, wealth managers who manage bespoke stock portfolios for their clients are actively managing that capital.
- Any mutual fund that has an investment objective of outperforming a benchmark is actively managed.
- All hedge funds are actively managed.
- Some quantitative funds are actively managed, though decisions are made in a systematic way.
- Pension funds are usually actively managed, though they do allocate increasing amounts of capital to passive investments.
Passive funds take fewer forms:
- ETFs like the SPY fund that tracks the S&P 500 index, and the Vanguard FTSE Emerging Markets ETF are both passive investing products. The vast majority of ETFs are passively managed.
- Index funds in the form of mutual funds also follow a passive investing strategy.
- Robo advisors invest client money according to automated asset allocation models. These platforms invest client savings in ETFs. The asset allocation models themselves are mostly passive and make only small changes over time.
There are also a few examples of hybrid strategies that straddle both the active and passive investing industry:
- Smart beta ETFs attempt to improve on the performance of market cap-weighted indices. While these are index funds, the index funds are adjusted more frequently than market cap indices.
- ETF rotation strategies use tactical asset allocation models to move money between ETFs. Although the capital is invested in passive funds, the asset allocation is actively managed by the model.
- Quantitative investing funds based on empirical evidence have varying degrees of turnover. Most quant funds have low turnover, though some are more active than others.
Active vs. passive: Which investment strategy is better?
The active vs. passive debate has been taking place for over two decades. It is now becoming apparent that rather than choosing between the two approaches, investors should consider which is most appropriate in each unique case. There are almost certainly times when one or the other makes more sense. In most cases, a combination of active and passive strategies is more appropriate.
For investors with small accounts and those making small monthly contributions to an account, ETFs are the only suitably cost-effective solution. In that case fees matter more than the investing strategy. The fact that most active funds underperform their benchmarks can be a misleading way to judge them. In many cases, active funds have risk management objectives as well as simple return objectives. Moreover, active funds tend to outperform during bear markets, while passive funds often outperform during bull markets.
An individual stock’s return is affected by three factors; the company’s financial performance, the performance of the sector, and the performance of the overall market. So, of these three factors, two can be earned using index funds at low costs. It therefore makes sense to dedicate a substantial portion of a fund to index funds that earn market returns with the lowest cost possible.
A second portion of the fund can then be allocated to active strategies that can actually make a difference to overall performance. The mistake is to pay high fees for funds that are only likely to earn market returns. An allocation to active investing could be focussed on a small number of high conviction ideas that offer the opportunity to earn alpha. Hedge funds that have the ability to use leverage and short selling could also fall into this part of a portfolio.
Investment industry trends
The emergence of passive investing has been an important step in the evolution of portfolio management. Active management may, however, make something of a comeback in the next decade. There are several reasons for this.
Firstly, after a decade long bull market in equities, the probability of low returns from equities in the next few years is high. This may leave ETF investors disappointed and reconsidering alternatives. Large-cap technology stocks dominate the largest market indices, which may at some point lead to these indices underperforming other sectors. If that happens, active managers would be at a distinct advantage.
Active managers and those who design smart beta strategies pay much attention to risk management, sometimes at the expense of upside. Many of the newest products have yet to be tested by a bear market, and the next major stock market crash is likely to set up the playing field for the future.
New technologies are also giving active managers tools that were previously unavailable. Big data, artificial intelligence, and machine learning are allowing active managers to find new ways to generate alpha. For example, Catana Capital’s Data Intelligence Fund uses real-time, user-generated data to measure market sentiment.
There is also a lot changing with regard to the way financial advisors operate. The emergence of robo advisors has made new technologies available to traditional advisors. The digitization of the advice industry may create opportunities for a whole new range of active and hybrid products.
So, while passive investing products may always be an essential building block for portfolios, there is every chance that new, different types of active products will be launched in the future.
Conclusion: Active & passive investing within a diversified portfolio
Both passive and active investing strategies can serve a purpose in a diversified portfolio. In fact, in most cases it makes sense to include both, as passive strategies can be used to reduce fees and active strategies can improve the risk reward profile. In the future we are likely to see a wider assortment of hybrid products emerging and the distinction between active and passive investing may become blurred again.