Active vs. Passive Investing: Which is best for you?
One is not necessarily better than the other. Find out the pros and cons, the virtues and shortcomings of passive and active investing.
The debate between active and passive investing has been going on for quite a while now, with strong advocates on either side. However, despite the strong opinions and many arguments within the financial community, these terms may sound foreign to many.
So what do they mean, really? Let’s talk about the mindset behind each strategy, their pros and cons, and how and when to apply them.
Just keep in mind that while the discussion on active vs passive discussion happens mostly in the equities space, these concepts apply to fixed income, i.e., bonds, and other asset classes as well.
Put simply, an active approach to investing involves monitoring prices of investment positions to “actively” buy or sell to maximize gains and minimize losses. Active investing can be done by the individual investors themselves, or portfolio managers who can do the work for them for a fee.
The goal of every active fund is to beat the benchmark for its asset class. Because of this, active fund performance is measured by how much better or worse they perform relative to the market. This excess return above the benchmark is known as alpha.
To achieve high alpha, active investors generally apply a combination of analytical tools, market expertise, experience, and even “gut feel” in order to make the best possible investment decision at that point in time. This is a more involved process and entails frequent trading and continuous monitoring of the portfolio, thus it naturally comes at a higher cost vs. passive investing.
Known also as “index investing” or indexing, passive investing mainly involves buying into index funds or exchange-traded fund (ETFs) with the goal of matching the performance of the chosen index or benchmark. This is a more hands-free approach with less frequent monitoring and trading.
The main philosophy driving passive investors is called the efficient market hypothesis, which states that markets are efficient and shares are always fairly priced because they reflect all information available to investors at any given time. According to the theory, consistent alpha generation, or consistently beating the benchmark, is impossible.
What approach is better, and when?
One popular proponent of passive investing is Warren Buffett, CEO of Berkshire Hathaway and currently one of the five richest people in the world. If you think about it, it seems ironic since he runs a business managing active investments.
Why is that so? What’s the difference? Simply put, it’s about time and experience.
Mr. Buffett’s advice is directed toward the average investor, for whom it is widely accepted that a passive portfolio works best over the long term. Statistics support this as well. Nearly 80% of actively managed US equity funds do not manage to outperform their respective benchmarks. A passive portfolio requires minimal expertise and less time spent monitoring the portfolio as indices typically only have quarterly “rebalancing” or adjustment periods to reflect intended changes in its composition.
Active portfolios, however, do have their own merits. At peak levels, active funds have been known to post year-on-year gains well above the benchmark. Due to their nature, active funds can also react more swiftly to changes in market conditions, especially in highly volatile periods. As stated earlier, this more hands-on approach also entails higher fees, which may cut any gains you may have.
Here’s a brief summary of the benefits and disadvantages of each approach:
Despite the comparisons between the two, it’s always best to remember that you don’t have to pick just one or the other. While some would prefer to stick to a single investment strategy, there are many portfolios that have both active and passive components. The active portion provides the opportunity to achieve high returns, while the passive portion grants stability and steady returns over the longer term.
Whatever strategy you decide on, I personally believe there is no wrong choice. Be it active or passive, bonds or equities, simple or complex, the key word here is “investment”. We invest to grow our wealth to enhance or preserve our quality of life. The means may vary, but the goal has always remained the same.
To quote the famous economist Benjamin Graham: “The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”
DANIEL ANDREW TAN is a Relationship Manager for Metrobank’s Private Wealth Division, whose function mainly involves providing investment and wealth management advice to the Ultra-High-Net-Worth Individuals (UHNWI). He brings with him over fifteen years of experience in both retail banking and financial markets, and avidly monitors Philippine equities. He applies both active and passive investment strategies to his personal portfolio and strongly advocates for a “tailored” approach to investments.