Investors and academics have been debating the merits of “active” versus “passive” investing for more than 20 years. There’s no doubt passive investing has become more popular over this period, with over $10 Trillion now invested in Exchange-Traded Funds (ETFs) alone.
Active Investing:
Active investing as its name implies, takes a hands-on approach. The goal of an active fund manager is to “beat the market,” or outperform specific benchmarks. It requires a high level of analysis and expertise to determine what assets should be bought and sold, as well as the timing of these.
In volatile markets, an active manager may have the flexibility to move to a defensive position to minimise losses.
Active managers also have tools available to them such as hedging, shorting, leverage etc. which they can use to enhance returns.
The downside to active investment is higher fees, which are needed to cover the cost of research and trading. If a fund has a cost of 1% pa, the manager needs to outperform the market by at least 1% before they add value.
Passive Investing:
Passive investing is a hands-off approach with the aim of duplicating the performance of a particular market or index.
The major benefit of this approach is the lower costs.
Typically, these can provide more diversification as you may be investing in hundreds or thousands of individual stocks and bonds.
During a bear market, passive investing offers no place to hide and the option to minimise losses doesn’t exist.
Which is best?
Thankfully, it doesn’t have to be an either/or choice. Blending the two and using a “hybrid” approach can help diversify a portfolio and manage the risk.
It is well known that only a small percentage of active managers outperform their benchmarks. If you’re looking to invest in very efficient market like US Large Caps, then a passive strategy may be a better option.
For less efficient/liquid markets or certain niche sectors, an active manager may have specialist knowledge that gives him/her an edge and therefore justifies the additional cost.
