When it comes to investing, there is a whole world of choice out there. With over 3,000 types of funds to choose from in the UK, from mutual funds, closed-end funds, index funds and active funds, it can be overwhelming. And one of the biggest debates out there is whether active vs passive investing is best.
Investing plays a large part in a financial planning strategy, so how do you decide which investment strategy is for you? The truth of the matter is that there is no correct answer. It’s dependant on which approach suits you.
A brief history of investing
In 1602 Dutch East India Company was the first to issue shares on an exchange. Fast forward 322 years, The Massachusetts Investors Trust was the first actively managed mutual fund created in the US in 1924. By the 1950s, there were over 100 mutual funds, with hundreds more launched in the 60s.
In 1951 a thesis by John (Jack) Bogle concluded that active fund managers couldn’t beat the market and first introduced the idea of an index fund.
Eugene Fama’s Efficient Market Hypothesis (EMH) published in the 1960s claimed asset prices reflect all available information, therefore as a direct result, it’s impossible to ‘beat the market’ consistently.
After founding Vanguard Group in 1975, Bogle, inspired by the works of Nobel Laureate Paul Samuelson, created the first passive index called the First Index Investment Trust (now Vanguard 500), which tracked the S&P 500.
And the debate over passive and active was born.
What’s the difference between active and passive investing?
When faced with choices, it’s best to break it down and start with the basics.
Active investing
- Active management picks stocks, buying when funds are undervalued and selling them when they are overvalued, intending to outperform the market and its benchmark.
- Investors pay a fee for the expertise and experience of a portfolio manager and their specialist investment team. There will also be trading costs for the buys and sells they make.
Passive investing
- Passive fund managers imitate a benchmark and don’t buy and sell funds at their will. They aim to be in-line with or track the market, not outperform it.
- Trades are triggered when the benchmark changes, not because of research.
- The lower number of trades reduces the cost and lowers the risk.
Advantages and disadvantages of active vs passive investing
- Returns
Active portfolio management provides an opportunity to exceed market returns. However, there is also the chance of underperformance. The return relies on the skill of the manager.
On the other hand, passive portfolio management typically provides returns in-line with the market, with no objective to beat it. So, returns might be smaller but pose less risk.
- Risk
Active funds tend to have a higher risk, as they have lower diversification and higher volatility due to stock picking. Whilst the manager can reap the rewards of a good choice, poor choices are also a possibility. With that said, active managers can minimise potential losses and adapt to market volatility.
Passive funds follow the buy-and-hold strategy and focus on long term goals. There is no misjudgement. However, the lack of flexibility means they can’t adapt and change their holdings in market volatility.
- Flexibility
Active management allows greater flexibility of choice; stocks can alter and adapt to the market.
Passive funds are limited to a specific index or set of investments. They can’t vary this, even in times of market turbulence.
- Cost
One of the key benefits of a passive portfolio is its low cost and simplicity. Without someone picking stocks, management and oversight are much lower. They simply follow the benchmark and trade in-line with that.
Whereas with an active fund, each trade will trigger a transaction cost. There are also costs of paying the management and analyst team too.
According to the Money Advice Service, the average yearly cost of actively managed funds is 0.75%-1.25%, compared to 0.25%-0.85% for passive tracker funds. Although active investing aims to beat market returns, the relative cost could balance out overall returns.
Summary
There are pros and cons for both active vs passive investing. We all have different wants, needs and priorities. As with any financial decision, you must do your research and seek the advice of a professional.
If you would like to delve a little deeper into the realms of investing, here’s some recommended reading to help on your journey to making your money work harder for you:
- Learn the lingo with our A-Z guide to investing; part 1 and part 2
- Find top tips with MoneySavingExpert’s investing for beginners
- Understand the fundamentals with Smarter Investing by Tim Hale
- Understand the role of ethical investing and how to align your values with your investments
If you have any questions or would like to know more about how to invest and make smarter financial decisions, please get in touch and speak to one of our Financial Planners.
