Active vs. Passive Investing

One of the most important decisions investors must make is whether to be active or passive – or a mixture of both.

Daniel Liberto Published on 05 March 2021.
Active vs. Passive Investing

Much as with the Messi-Ronaldo debate, feelings about active vs. passive investing can run hot. Everyone has an opinion, and many of them are impartial, too, making it difficult to figure out which could work best for you and your funds.

Read on to learn the pros and cons of active vs. passive investing.

What is active investing?

Active investing is a hands-on approach characterised by frequent buying and selling. It is typically employed by experienced investors or professional fund managers, who have full control over how to invest the money. The fund manager handpicks the most attractive opportunities, and then makes changes when necessary. Active investors try to anticipate and beat the market.

What is passive investing?

Passive investing, as its name implies, is a more hands-off approach. Passive funds aim to replicate the performance of a particular stock market index — a collection of securities chosen to represent a particular segment of the market — often by simply investing in every firm in it.

Pros and cons of active and passive investing

At first glance, the active route might seem the more appealing option. Handing over your money to a team of experts to manage is certainly more reassuring than the idea of investing it on autopilot.

However, over the past few years UK investors have been steadily moving towards a passive approach. One big reason: costs.

Investors foot the bill for the everyday running of a fund. Active funds pay experienced staff to pick, monitor and adjust investments, and charges can be higher as a result. Passive funds, in contrast, require minimal maintenance and thus are relatively cheap to operate.

We’re not talking the difference of a few pennies here. This price gap can stack up over the years, significantly impacting returns. This gives passive funds a big head start and makes it even more difficult for their actively-run rivals to beat the benchmarks they are tasked with outperforming.

Of course, passive funds aren’t perfect. Not all of them are cheap enough to warrant selection, and some only partially mimic the index they’re designed to track.

The fact that most are market capitalisation-weighted is another controversial issue. What this means is poor quality assets become a smaller slice of total holdings as their valuations shrink or, on the flipside, more of your money is invested in heavily bought assets with increased price tags that are prone to sharp sell-offs at the first sign of trouble.

Pros and cons of active investing

Pros Cons
  • Greater upside potential: Active funds attempt to beat the market rather than just replicate it
  • A team of experts select the best investments out of a much larger pool on your behalf
  • Fund managers can buy and sell at any time, ensuring investments are tailored to reflect current conditions
  • Most active managers fail to consistently beat the market, especially when taking their fees into account
  • There’s no guarantee of continued success
  • Less transparent: Active managers generally don’t like to disclose their holdings out of fear their ideas could be stolen by competitors

Pros and cons of passive investing

Pros Cons
  • Low operating expenses
  • Provide broad access to entire markets and increased exposure to growing investments with momentum
  • Performance capped by index
  • Valuations might get knocked during downturns
  • Most are market capitalisation-weighted, meaning potentially overvalued assets could make up a larger proportion of holdings

Which strategy could be best for me?

Choosing whether to go active or passive is a personal decision that hinges on a number of factors, including your personal investment goals, risk tolerance and confidence that the active manager can justify the higher charges.

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Passive investing generally works best in broad established markets where the dispersion of returns is low. Active funds tend to thrive more in specialist, complex areas where variation is rife, and trackers or exchange-traded funds (ETFs) are in limited supply.

But it doesn’t have to be one or the other. The two approaches can be used in tandem, allowing investors to try to beat the market and simultaneously profit from its overall momentum.

Remember, Investments can rise and fall. You may get back less than you invest. Past performance is no guarantee of future results.

This is an informational guide and does not constitute advice. The content does not take into account personal, financial and tax circumstances of the reader. Before proceeding with any kind of investment, qualified professional advice should be sought.

Image Source: Getty Images

About the author:

Daniel is a freelance finance journalist. He has written and edited news, deeper analysis features, and opinion pieces for the Financial Times, Investopedia and the Investors Chronicle. Read more

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