What is Active vs. Passive Investing?
Active vs Passive Investing is a long-standing debate within the investment community, with the central question being whether the returns from active management justify a higher fee structure.
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:
- “Beat the Market” – i.e. Earn returns higher than the average stock market returns (S&P 500)
- 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:
- Index Funds
- Exchange-Traded Funds (ETFs)
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: What is the Difference?
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.