Investors have been debating the relative merits of active and passive investing for many years. While some appreciate passive funds’ convenience and low cost, others favour active funds’ potential to outperform the market.
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Here, we explain the differences between the two investment styles, and why combining the two enables us to maximise returns for clients.
Passive investing
The objective of passive investing is to track a specific index, commodity, or basket of assets. If a fund tracks the FTSE 100, for example, its goal will be to match the performance of that index. As well as tracking well-known indices, passive funds might target more specific countries, sectors, industries, sub-industries or factors.
Passive funds provide a convenient and inexpensive way of gaining exposure to assets that might be cumbersome and expensive to buy direct (such as gold) or logistically challenging to buy direct (imagine investing in every company in the S&P 500!).
Passive funds may also prove useful when investing in an industry where the competitive environment is ever-changing. With cyber security, for example, the playing field moves with every new threat and resulting technology to combat it; it’s very challenging to select a couple of winners.
The downside of passive investing is there is no intention to outperform the market. The fund’s performance should match the index, whether it rises or falls.
Active investing
Active managers aim to outperform a particular index (their ‘benchmark’) by taking advantage of market inefficiencies. Active managers will hold stocks within their benchmark where they see opportunity for attractive returns, and omit holdings that they consider to be poor quality or expensive. They can also buy stocks outside of their benchmark.
Active managers look for opportunities where assets are mispriced. These opportunities are more likely to be in markets that are less well covered and less liquid, such as emerging markets and small cap stocks. At RBC Brewin Dolphin, we use active managers to gain exposure to such markets; their experience, knowledge and deep cultural understanding of their universes are of significant value.
Changing market environments might also present mispricing opportunities. Active managers performed strongly in 2020 when Covid-19 brought about dramatic and swift changes in consumer behaviour. The ‘stay at home’ stocks boomed while leisure stocks languished.
One of the biggest benefits of active management is that you can be the ‘tortoise’ rather than the ‘hare’ if you have the benefit of a longer time horizon. Warren Buffett and Terry Smith share our philosophy that companies with superior returns on investment, with the opportunities to reinvest those proceeds at attractive rates, will outperform over the long run.
The downside of active investing is there is no guarantee that active funds will outperform their benchmark, particularly once the higher fees are taken into consideration.
Active vs passive – key characteristics
Active funds
Passive funds
Objective
Outperform their benchmark
Track a specific index, commodity, or basket of assets
Strategy
Select assets that offer promising investment opportunities
Replicate the performance of the underlying index
Pros
Potential to capture mispricing opportunities and beat the market
Convenient and low-cost way of gaining exposure to certain assets/industries
Cons
Fees are typically higher and there is no guarantee of outperformance
No opportunity to outperform the market
Best of both worlds
We believe that active and passive funds both have a role to play in a diversified investment portfolio. Whenever possible, we invest in a core of individual equities that we believe will outperform our benchmark over the longer term, but will also access external active management capabilities in markets and strategies which are outside of our expertise. We use passive funds as a cost-effective way of achieving broader market participation, or more specific exposure on a short-term basis.
By utilising different assets that are available to us, we aim to steer portfolios through market cycles while capturing mispricing opportunities along the way.
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The value of investments can fall and you may get back less than you invested. Information is provided only as an example and is not a recommendation to pursue a particular strategy.
Risk: Active funds have a higher risk than passive funds, as they are subject to the fund manager's skill, judgment, and errors. Passive funds have a lower risk than active funds, as they eliminate the human factor and closely mirror the index, resulting in lower volatility and tracking error.
All those fees over decades of investing can kill returns. Active risk: Active managers are free to buy any investment they believe meets their criteria. Management risk: Fund managers are human, so they can make costly investing mistakes.
Too many limitations: Passive funds are limited to a specific index or predetermined set of investments with little to no variance. Thus, investors are locked into those holdings, no matter what happens in the market.
For example, when the market is volatile or the economy is weakening, active managers may outperform more often than when it is not. Conversely, when specific securities within the market are moving in unison or equity valuations are more uniform, passive strategies may be the better way to go.
Any investor who is new to equity market, should invest in passive funds. New investors generally are unaware of the risks and dynamics of equity markets. Hence it is advised to start with passive investment before getting actively involved.
Simplicity: Passive investments are simpler to administer and track than mutual funds with an active management: a fund manager sticks to the underlying index, and rebalances the scheme only when there are changes in the underlying index, which may change the index constituents based on a transparent index methodology.
When all goes well, active investing can deliver better performance over time. But when it doesn't, an active fund's performance can lag that of its benchmark index. Either way, you'll pay more for an active fund than for a passive fund.
Active risk arises from actively managed portfolios, such as those of mutual funds or hedge funds, as it seeks to beat its benchmark. Specifically, active risk is the difference between the managed portfolio's return less the benchmark return over some time period.
That is, in a market downturn, there may be a rush for the exits as both passive and active investors get out of large cap stocks. This may become even more of an issue as passive funds continue to take market share from active peers.
Passive investors hold assets long term, which means paying less in taxes. Lower Risk: Passive investing can lower risk, because you're investing in a broad mix of asset classes and industries, as opposed to relying on the performance of individual stock.
For those who have no reason to hop into anything risky, passive management provides about as much security as can be expected. Because passive investments tend to follow the market, which tends to experience steady growth over time, the chance you'll lose your invested assets is low in the long run.
Between the active voice and passive voice, the active is more confident and authoritative. It makes you seem like you know what you're talking about, even if you don't. It's also more economical, in that you need fewer words to convey your ideas.
Active management has benefits, such as the potential for higher returns, the ability to adjust to market conditions, and the opportunity for diversification. However, active management also has drawbacks, such as higher fees, difficulty in consistently outperforming the market, and the risk of human error.
The primary advantages of investing are the opportunity to grow your principal and earn passive income. Unfortunately, these benefits come with the possibility of losing some or all of your principal. In addition to the downside exposure, many investment instruments are inherently complex.
Actively managed funds generally have higher fees and are less tax-efficient than passively managed funds. The investor is paying for the sustained efforts of investment advisers who specialize in active investment, and for the potential for higher returns than the markets as a whole.
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