Active vs passive investing: What is the difference?
Are you exploring the difference between active and passive investing? Each investing style has its own pros and cons, but what are they and which approach is right for you?
What is the difference between active vs passive investing?
Active investing involves actively buying and selling securities, attempting to outperform the market, often with the guidance of a portfolio manager. Passive investing takes a more hands-off approach by tracking a market index and aims to match its performance, typically achieved through investing in index funds or ETFs.
Active investing involves actively managing a portfolio by making frequent trades and attempting to obtain returns above the markets. Active investors rely on research, analysis, and market timing to identify undervalued securities and take advantage of short-term price movements. They aim to beat the market and generate higher returns through active decision-making.
On the other hand, passive investing involves taking a more hands-off approach by tracking a market index or a specific asset class. Passive investors aim to replicate the performance of a particular market or asset class without actively selecting individual stocks or timing trades. Passive investment strategies commonly utilise index funds or exchange-traded funds (ETFs) that mirror the performance of a specific benchmark.
Which approach is right for you
Active investing requires significant time, effort, and expertise to research, analyse, and monitor investments actively. It often involves higher costs due to transaction fees, management fees, and potential tax implications. The success of active investing depends on the investor's ability to consistently make accurate investment decisions and outperform the market.
Passive investing, on the other hand, aims to capture the average market return and is often considered a more "hands-off" approach. It offers simplicity, lower costs, and broader diversification through index funds or ETFs. Passive investors believe that markets are generally efficient, making it difficult to consistently beat the market over the long term. Therefore, they choose to minimise active decision-making and instead focus on long-term investing strategies.
Both the active and passive styles of investing have their advantages and drawbacks, and the choice between the two ultimately depends on an investor's goals, risk tolerance, time commitment, and investment philosophy.
Pros and cons of active investing
Potential for higher returns by outperforming the market
Higher costs associated with frequent trading, research, and analysis
Active involvement allows for more control and decision-making
Requires significant time commitment and expertise to research and monitor investments
Ability to take advantage of short-term price movements and market inefficiencies
Increased risk of underperforming the market or making poor investment decisions
Potential for active tax management strategies to optimise returns
Greater susceptibility to emotional biases and behavioural pitfalls
Flexibility to adjust investment strategies based on market conditions
Difficulty in consistently outperforming the market over the long term
Possibility to uncover undervalued securities
Potential for higher tax liabilities due to frequent trading
Opportunity to invest in niche or specialised sectors
Possibility of market timing mistakes leading to missed opportunities or losses
Pros and cons of passive investing
Broad market exposure and diversification
Limited ability to outperform the market or take advantage of short-term opportunities
Lower costs due to fewer transactions and management fees
Unable to deviate from the performance of the underlying index or benchmark
Simplicity and ease of implementation
No active decision-making or control over individual holdings
Reduced time commitment as it requires less research and monitoring
Vulnerability to market downturns without active risk management strategies
Long-term focus aligns with the principles of buy-and-hold investing
May experience larger losses during severe market downturns
Lower portfolio turnover, potentially leading to fewer tax implications
Limited ability to invest in specific companies or sectors of interest
Tendency to capture the overall market returns over time
Market inefficiencies or mispricing may not be exploited
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What is an example of an active and passive investment?
Active investment example
An example of an active investment is a mutual fund managed by a portfolio manager who actively selects and trades individual stocks or other securities with the goal of outperforming the market.
The portfolio manager conducts in-depth research, analyses financial statements, and makes investment decisions based on their expertise and market outlook. They aim to beat the market by identifying undervalued or high-growth potential securities.
Active investment strategies can also include trading in options, futures, or other derivatives to enhance returns or manage investing risks. The performance of an actively managed mutual fund will vary based on the fund manager's investment decisions.
Passive investment example
An example of a passive investment is an index fund that tracks a specific market index, such as Vanguard Australian Shares Index ETF ($VAS). These funds aim to replicate the performance of the underlying index by holding a diversified portfolio of stocks that mirror the index's composition.
Passive investors typically buy and hold these funds for the long term, allowing their investments to align with the overall market returns. They do not actively trade or try to outperform the market. Index funds are popular passive investment options as they offer broad market exposure, low fees, and the convenience of diversification. Passive investors believe in the efficiency of markets and the long-term benefits of staying invested in the market as a whole.
Example of active and passive strategies
Actively managed portfolio strategy
An example of an actively managed portfolio strategy is a growth-oriented investment approach. In this strategy, active managers seek out companies or sectors with high growth potential and invest in their stock. The portfolio managers conduct extensive research, analysis, and valuation to identify companies that they believe will experience significant growth in the future.
The managers may focus on various factors such as revenue growth, earnings growth, market share, competitive advantage, and industry trends to make their investment decisions. They continuously monitor and adjust the portfolio holdings based on their analysis and market conditions. The goal of the actively managed portfolio strategy is to outperform the overall market or a specific benchmark index by selecting securities that are expected to generate superior returns.
The portfolio managers of active strategies may engage in frequent buying and selling of securities, attempting to capture short-term market movements and take advantage of perceived opportunities. This strategy requires active decision-making, expertise, and market timing skills. The success of active investments depends on the portfolio manager's ability to consistently make accurate investment decisions and generate higher returns than the market average.
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Passively managed portfolio strategy
An example of a passively managed portfolio strategy is investing in a passive fund, such as a broad-based index fund. In this strategy, investors aim to replicate the performance of a specific market index, such as the S&P 500 or the ASX 200, rather than attempting to outperform it.
Passive managers construct the portfolio to mirror the composition of the chosen index by holding a diversified set of stocks or securities in the same proportion as the index. They do not actively trade or make individual security selection decisions. Instead, they focus on maintaining the same asset allocation and weighting as the underlying index.
Passive strategies are designed to capture the overall market returns over the long term rather than trying to beat the market. By investing in an index fund, investors gain exposure to a broad range of companies within the chosen index, providing diversification and reducing the risk associated with individual stock selection.
Passively managed portfolio strategies often involve lower costs compared to actively managed fund strategies, as there is less trading activity and research involved. Investors typically hold their investments for the long term, taking a buy-and-hold approach, and avoid making frequent changes based on market conditions.
Passive strategies are based on the belief that markets are generally efficient, and it is challenging to consistently outperform the market over time. Instead, investors in passively managed portfolios aim to achieve returns that closely align with the overall market or benchmark performance.
Can you do both active and passive investing?
Yes, it is possible to combine both passive and active investing strategies through an approach known as the core-satellite investing strategy. The core-satellite strategy involves building a diversified investment portfolio that consists of a "core" passive component and a "satellite" active component.
In this strategy, the core portion of the portfolio is allocated to passive investments such as broad-based index funds or ETFs. The passive core provides broad market exposure and aims to capture the overall market returns over the long term. It offers diversification, lower costs, and a foundation of stable returns.
The satellite portion of the portfolio is allocated to actively managed investments. This could include actively managed funds, individual stocks, or other securities selected by the investor or portfolio manager. The satellite component is intended to provide the potential for outperformance or focus on specific investment themes or sectors that the investor or active manager believes will generate higher returns.
The core-satellite strategy allows investors to benefit from the advantages of both active and passive investing. The passive core provides stability, broad market exposure, and cost efficiency, while the active satellite components offer the potential for alpha generation or customisation to suit the investor's specific investment goals and beliefs.
This strategy provides a balance between the passive approach's long-term consistency and the active approach's potential for higher returns or specialised investments.
Do active or passive funds perform better?
The performance of active and passive funds can vary, and it is challenging to make a definitive statement about which type consistently performs better. The performance of active funds largely depends on the skill and expertise of the fund managers in making successful investment decisions.
Studies have shown that over longer time periods, a significant percentage of actively managed funds may not outperform their respective benchmark indices after accounting for fees and expenses. This is attributed to factors such as higher costs, the difficulty of consistently selecting winning securities, and the challenge of overcoming market inefficiencies.
Passive funds, by design, deliver returns in line with the overall market. Passive funds generally have lower costs due to their passive investment approach and lack of frequent trading.
It is worth noting that there can be periods when active funds outperform passive funds, especially during certain market cycles or when skilled active fund managers identify lucrative investment opportunities. However, consistently identifying those opportunities and outperforming the market over the long term is challenging.
How to know which management style is best for you?
Determining which investment management style that works for you involves considering various factors. Here are some key considerations to help you make an informed decision:
- Investment goals: Clarify your investment objectives. Are you seeking long-term growth, capital preservation, income generation, or a combination? Understanding your goals will help determine which approach aligns better with your desired outcomes.
- Risk tolerance: Assess your risk tolerance. Active investing often involves higher risks due to potential market timing, individual security selection, and concentration in specific sectors. Passive investing typically provides broader diversification and more stable returns, which may suit investors with lower risk tolerance.
- Time commitment: Evaluate the time you can devote to managing your investments. Active investing typically requires more time and effort for research, analysis, and monitoring of individual securities. Passive investing requires less active involvement as you mainly track the market or specific index.
- Expertise and interest: Consider your knowledge and interest in investment research and analysis. Active investing demands a deeper understanding of markets, financial statements, and valuation techniques. Passive investing, while still requiring basic investment knowledge, is relatively simpler and doesn't require constant research.
- Cost considerations: Assess the associated costs. Active investing often incurs higher fees due to transaction costs, management fees, and potential tax implications. Passive investing tends to have lower costs since it involves minimal trading and typically utilises low-cost index funds or ETFs.
- Performance expectations: Reflect on your expectations for investment performance. Active investing aims to outperform the market, but success is not guaranteed and beating the market consistently is challenging. Passive investing seeks to capture market returns over the long term without attempting to beat the market.
- Market efficiency beliefs: Consider your beliefs about market efficiency. Active investing assumes that markets have inefficiencies that can be exploited for superior returns. Passive investing is based on the belief that markets are generally efficient, making it difficult to consistently outperform the market.
It's important to note that you don't have to exclusively choose one management style. Many investors adopt a blended approach, combining both active and passive strategies in their same portfolio management program (e.g., core-satellite strategy) to diversify risk and leverage the strengths of each approach.
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Active vs passive investing FAQs
How much of the market is passively invested?
Industry research suggests that passive investing has gained significant traction in the U.S. stock market. As of 2021, approximately 17% of the U.S. stock market is passively invested, a remarkable increase from previous years. This growth is expected to continue, with projections indicating that passive investing will surpass active trading in terms of market share by 2026.
The rise of passive strategies is also evident in the mutual fund industry, where passive index strategies have witnessed substantial growth. Around 54% of the U.S. domestic equity-fund market is allocated to passive funds, surpassing the assets under active management. The shift in investor preference towards passive funds started to manifest in 2018, marking a significant milestone in the investment landscape.
Which management style has lower fees?
Passive management strategies generally have lower fees compared to active management. This is primarily because passive strategies aim to replicate the performance of an index or benchmark, which means there is less active trading happening. With fewer transactions and lower operational costs, passive investments tend to offer investors a cost advantage, resulting in lower expense ratios and fees.
However, it's important to review the specific fees associated with any investment product, as costs can still vary within both active and passive options.
Stella is a markets analyst and writer with almost a decade of investing experience. With a Masters in Accounting from the University of Sydney, she specialises in financial statement analysis and financial modelling. Previously, she worked as an equity analyst at Australian finance start-up, Simply Wall St, where she took charge of the market insights newsletter sent out to over a million subscribers. At Stake, Stella has been key to producing the weekly Wrap articles and social media content.