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Active vs. Passive Investing

Understand the Difference Between Active vs. Passive Investing

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Active vs. Passive Investing

Active Investing Definition

By strategically weighing a portfolio more towards individual equities (or industries/sectors) – while managing risk – an active manager seeks to outperform the broader market.

Active investing is the management of a portfolio with a “hands-on” approach with constant monitoring (and adjusting of portfolio holdings) by investment professionals.

The objective varies by the fund, however, the two primary objectives are to:

  1. “Beat the Market” – i.e. Earn returns higher than the average stock market returns (S&P 500)
  2. Market-Independent Returns – i.e. Reduced Volatility and Stable Returns Regardless of Market Conditions

The latter is more representative of the original intent of hedge funds, whereas the former is the objective many funds have gravitated toward in recent times.

Advocates for active management are under the belief that a portfolio can outperform market benchmark indices by:

  • Going “Long” on Undervalued Equities (e.g. Stocks Benefiting from Market Trends)
  • Going “Short” on Overvalued Equities (e.g. Stocks with a Negative Outlook)

Active managers attempt to determine which assets are underpriced and likely to outperform the market (or currently overvalued to short sell) through the detailed analysis of:

  • Financial Statements and Public Filings (i.e. Fundamental Analysis)
  • Earnings Calls
  • Corporate Growth Strategies
  • Developing Market Trends (Short-Term and Long-Term)
  • Macroeconomic Conditions
  • Prevailing Investor Sentiment (Intrinsic Value vs Current Trading Price)

Examples of actively managed funds are:

Passive Investing Definition

Conversely, passive investing (i.e. “indexing”) captures the overall market returns under the assumption that outperforming the market consistently over the long term is futile.

In other words, most of those who opt for passive investing believe that the Efficient Market Hypothesis (EMH) to be true to some extent.

Two common choices available to both retail and institutional investors are:

Passive investors, relative to active investors, tend to have a longer-term investing horizon and operate under the presumption that the stock market goes up over time.

Thus, downturns in the economy and/or fluctuations are viewed as temporary and a necessary aspect of the markets (or a potential opportunity to lower the purchase price – i.e. “dollar cost averaging”).

Besides the general convenience of passive investing strategies, they are also more cost-effective, especially at scale (i.e. economies of scale).

Active vs Passive Investing

Proponents of both active and passive investing have valid arguments for (or against) each approach.

Each approach has its own merits and inherent drawbacks that an investor must take into consideration.

There is no correct answer on which strategy is “better,” as it is highly subjective and dependent on the unique goals specific to every investor.

Active investing puts more capital towards certain individual stocks and industries, whereas index investing attempts to match the performance of an underlying benchmark.

Despite being more technical and requiring more expertise, active investing often gets it wrong even with the most in-depth fundamental analysis to back up a given investment thesis.

Moreover, if the fund employs riskier strategies – e.g. short selling, utilizing leverage, or trading options – then being incorrect can easily wipe out the yearly returns and cause the fund to underperform.

Historical Performance of Active vs Passive Investing

Predicting which equities will be “winners” and “losers” has become increasingly challenging, in part due to factors like:

  • The longest-running bull market the U.S. has been in, which began following the recovery from the Great Recession in 2008.
  • The increased amount of information available within the market, especially for equities with high trade volume and liquidity.
  • The greater amount of capital in the active management industry (e.g. hedge funds), making finding underpriced/overpriced securities more competitive.

Hedge funds were originally not actually meant to outperform the market but to generate low returns consistently regardless of whether the economy is expanding or contracting (and can capitalize and profit significantly during periods of uncertainty).

The closure of countless hedge funds that liquidated positions and returned investor capital to LPs after years of underperformance confirms the difficulty of beating the market over the long run.

Historically, passive investing has outperformed active investing strategies – but to reiterate, the fact that the U.S. stock market has been on an uptrend for more than a decade biases the comparison.

Warren Buffett vs Hedge Fund Industry Bet

In 2007, Warren Buffett made a decade-long public wager that active management strategies would underperform the returns of passive investing.

The wager was accepted by Ted Seides of Protégé Partners, a so-called “fund of funds” (i.e. a basket of hedge funds).

Buffett Hedge Fund Bet

Warren Buffett Commentary on Hedge Fund Bet (Source: 2016 Berkshire Hathaway Letter)

The S&P 500 index fund compounded a 7.1% annual gain over the next nine years, beating the average returns of 2.2% by the funds selected by Protégé Partners.

Note: The ten-year bet was cut early by Seides, who stated that “For all intents and purposes, the game is over. I lost”.

The purpose of the bet was attributable to Buffett’s criticism of the high fees (i.e. “2 and 20”) charged by hedge funds when historical data contradicts their ability to outperform the market.

Active Management and Passive Investing Pros/Cons Summary

To summarize the debate surrounding active vs passive investing and the various considerations:

  • Active investing provides the flexibility to invest in what you believe in, which turns out to be profitable if right, especially with a contrarian bet.
  • Passive investing removes the need to be “right” about market predictions and comes with far fewer fees than active investing since fewer resources (e.g. tools, professionals) are needed.
  • Active investing is speculative and can produce outsized gains if correct, but could also cause significant losses to be incurred by the fund if wrong.
  • Passive investments are designed to be long-term holdings that track a certain index (e.g. stock market, bonds, commodities).
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