What is the difference between active and passive investing?

Active and passive investing are terms which have been used frequently in the media lately as the debate continues over which one is better. In this article we discuss the differences between the two and the pros and cons of each.

Active management

An active management strategy is one where fund managers try and beat the market by actively managing the portfolio. An active portfolio manager seeks to identify and exploit opportunities to find mispricing in stocks in the market. Repeating this process over and over again successfully is how they beat the market.

Some of these advantages include

Limit losses: Active fund managers can move into and out of a position quickly if they are losing money on it. So there is downside protection with this strategy as they can be proactive about managing their positions

Profiting from a falling market: active funds can short stocks or buy put options and profit from a falling market, Passive investors can only be long, they can’t short a position.

Tailored to specific goals: active investing allows investors to choose investment strategies which cater for to their goals. For instance, an investor may want to invest in a fund which provides good income so they can use it to pay for their living expenses.

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Opportunity to generate high returns: The main aim of an active fund manager is to beat the market and generate higher returns as oppose to just tracking the market.

Disadvantages

High management fees: active fund managers charge a management fee when they beat the market. There are more resources used in an active fund manager to conduct research on stocks and this will be incorporated in the management fee.

Higher trading transaction costs: active portfolio management may mean being more dynamic in trading which can lead to higher transaction costs.

Passive investing

This is an investment strategy where you are just tracking the market index. Investors can invest in an index fund or an ETF that where the portfolio replicates the securities of a particular index. It is a buy and hold approach where investor do not need to pick individual stocks but just a fund or ETF which performs like the index. The composition of these ETFS or passive index funds only change when there is a change in the market index.

The passive portfolio management is built on the principle that markets are efficient so stock prices reflect the company’s intrinsic value. This strategy does not believe stocks are mispriced.

The advantages of this strategy are

Low fees: there are not many transactions involved as it is a buy and hold strategy

Tax efficiency: a passive managed fund creates less capital gains tax as there is less turnover of holdings. Active managed funds have turnover ratios of 20% or more where as passive managed funds only have a turnover of 1% or 2%. When the fund manager sells the stocks at a higher price as when they brought it, they will need to pay capital gains tax, hence frequent turnover can mean more capital gains tax.

Instant diversification: Passive investing achieves instant diversification as the ETF or fund is tracking the market.

The disadvantages are

Limited Upside: there is limited upside to this strategy as it merely tracks an index and doesn’t beat it

Risk Management: there is limited risk management as positions are not sold if there is market downfall, they are only sold if there is a change in the market index.

Cannot be tailored to individual goals: as these funds merely mirror the market, investors cannot pick individual stocks to cater to their goals.

Which is better?

It depends on your risk profile and time horizon of investing. Active investing has been better in periods of market weakness as this environment requires investors to be nimble.

Lauren Hua is a private client adviser at Fairmont Equities.

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