Active vs. Passive Investing

Which one Is right for you?

Ever since the first passive index fund was unveiled in 1975, the active vs. passive investing debate has been one of Wall Street’s most hotly contested issues. The discussions have become increasingly heated of late as the longest bull market in history saw active managers struggle to outperform their passive counterparts.

Endless script touting the relative merits of each is widely available, but ultimately, any final decision on your preferred approach will come down to personal preference.

In short, actively managed portfolios try to beat the performance of the market, while passively managed portfolios seek to track or mirror a market index rather than beat it.

Active Investing

As the name suggests, active investing is a more hands-on investment approach. As part of an actively managed fund, a portfolio manager and his/her team will continuously analyse the market, making changes to a portfolio based on what they believe will bring the most significant potential returns given the prevailing market conditions. Investing, however, is far from an exact science. Despite what their underlying analysis may have suggested, active managers can also get it wrong, resulting in market underperformance.

Benefits

• Opportunity to outperform the market
• Flexible approach to avail of opportunities
• Downside protection

Drawbacks

• Higher cost
• Less tax efficient
• Active risk

Passive Investing

In contrast, passive funds simply look to mimic the performance of a specific index.

One of the most common ways to invest passively is to buy index funds. These funds are made up of securities that mirror the securities held within a particular index. Let’s say you purchase a passively managed index fund that mimics the performance of the S&P 500 Index; if the S&P 500 (an index made up of 500 of the largest U.S companies) gains 12% in a year, that index fund should also move 12%.

Benefits

• Lower cost
• Hands-off approach
• Transparent

Drawbacks

• No downside protection
• No opportunity to outperform the market
• Lack of flexibility

So, which is better?

There seems to be a false dichotomy in place, whereby all active management is viewed as inherently evil, and all passive is preferred or vice versa. The reality is, the choice doesn’t need to be mutually exclusive. A blend of both can allow for a cost-efficient portfolio while still providing some room for outperformance through active management exposure.

For example, if you want exposure to the biggest companies in the U.S., you can get that very easily and cheaply through a passive ETF or Index Fund. On the other end of the spectrum, active management lends itself well to fixed income strategies and international markets, so if your exposure requirements are somewhat more nuanced, active management may be preferred.

Your preferred style may also change over time, depending on your age, goals, net worth, and timeline. When you are younger and less experienced, you may prefer the simplicity of passive investing. With less to invest, low fees and transparency make passive investing a good fit.

Suppose your situation is more complex with broader diversification requirements, or you have a higher net worth and are willing to take on more risks for potentially greater return. In these scenarios, you may need more custom options that come from active investing.

Regardless of your current preference, be sure you pick a strategy that’s not going to keep you up at night or cause you to panic sell at the least opportune time.