The Differences Between Active And Passive Investing

Posted by Simon Moore on December 12
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Often when you're reading about investing, you might see the words "active" and "passive" used. Let's explain what they mean.

Often when you're investing, part of your portfolio will be used to buy shares in companies (which represent a small stake in the profits the company makes). Now, the big question is, which shares to buy?

Passive and active approaches to investing answer that question differently. Also, active and passive investment strategies can apply to other investments like bonds too, but in this example we'll just discuss shares in our examples to keep it simpler.

 

An Active Approach

An active approach involves picking which shares to buy based on things that you know about a company. You might like the products the company sells, be impressed by its management, its track record, or see something in its financial reports or industry trends that perhaps others don't see. All of these approaches are active investing. You're doing your research and choosing shares that you like, and avoiding shares you don't, for any of a number of reasons.

This is the active approach. You are doing your own research and picking specific shares to buy. Even if you have a financial adviser doing all this for you backed by a team of analysts or complicated financial models, it's still considered an active approach.

 

A Passive Approach

Passive investment approaches are a little different. Typically, it might start with an index of shares. For example, the FTSE-100 tracks the largest companies by value in the UK.

A passive investor might own all 100 shares in the same proportion that they are held in the FTSE-100 index. This involves less choice or decision making, but the result is similar, the investor is still invested in the market.

Typically, passive investments involve less time and effort and are therefore generally less expensive than active strategies. Also, most of the time passive strategies can spread their investments broadly as it's not necessary to really like every share you invest in. This can lead to broader diversification (spreading your bets), which can make a portfolio less risky.

 

Pros and Cons

Both active and passive approaches have their advantages and disadvantages. Academic studies have typically shown that, perhaps surprisingly, active approaches, on average, tend to do worse over time than passive ones.

This is because outperforming the stock market is hard, because a lot of smart people are trying to do it. For every buyer there is a seller on the other side of the trade. This means that you may not get the results you expect from an active strategy. For every winner from active management there is likely an active management loser on the other side of the trade (and vice-versa).

Also, because active investing often means higher fees and costs, this can reduce the performance of the investment by offsetting any benefit than an active strategy might have. Sometimes, the results of active strategies can be unpredictable, further increasing investment risk.

Nonetheless, some active investors such as George Soros, Sir John Templeton or Warren Buffet have been very successful, and some active strategies do very well.

However, remember, you don't tend to hear about all the active investors who fail or lose money and give up. Also, often the best active investment products aren't always available to smaller investors as they concentrate their sales efforts on investors with large sums of money.

 

How ETFs Can Help Passive Investors

Recently ETFs (Exchange Traded Funds) have made it easier to invest passively. You can now buy shares directly that themselves are passive trackers of an index. This makes it easier than it used to be to implement a passive approach.

A single ETF can provide access to sometimes thousands of individual shares or other investments. ETFs can also include more advanced features such as currency hedging. Passive may not sound as glamourous as active investing, but its track record compared to active investing is impressive and robust in our view. It turns out that tracking well constructed benchmarks and keeping costs low has been a solid performer historically.

That's why in recent years some of the fastest growing investment products have been passive ETFs, while investments in certain active strategies have declined. However, it's important to remember that part of the reason for this in our view is that active strategies are generally higher cost whereas passive strategies are typically lower cost. We believe that it's, in part, the cost advantage that helps give passive strategies an investment edge.

 

Written by Simon Moore

He was previously CIO of FutureAdvisor, a US digital advisor. His most recent book Digital Wealth, explains automated investing. He studied economics at Oxford, and completed his MBA at the Kellogg School of Management.

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