An important and frequently discussed topic that has captured the attention of millions of investors — beginners to advanced? Active vs. passive investing. While the two strategies use different techniques, each strategy’s objective is to yield positive inflation-adjusted returns to the investor.
As an investor, understanding both strategies can help you make well-informed choices that meet your criteria and preferences. Let’s take a look at active vs. passive investing.
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What is passive investing?
At the heart of passive investing is the Efficient Market Hypothesis which hypothesizes that stocks trade at their fair market value, and therefore extremely difficult to beat.
Advocates of passive investing focus on the capital market’s ability to generate positive returns over the long run. As a result, passive investing attempts to create wealth gradually, by holding securities over an extended period of time. The strategy has gained tremendous popularity over the last 10 years.
A passive investing strategy aims to duplicate the returns of the overall market. How? By following a specific index, such as the S&P 500. The two biggest ways of doing this are through index funds, and more specifically, exchange-traded funds (ETFs).
Index funds are a type of mutual fund or ETF that matches or tracks specific market indexes. Since they are portfolios of stocks or bonds from a variety of industries and/or companies (small-, medium-, and large-cap), you’re essentially putting your eggs into several different baskets. Diversification, after all, is a pretty big cornerstone of investing.
ETFs trade like stocks, but instead of a particular company, the fund is a collection of securities traded together on the stock market. If you buy an index-mirroring ETF, it will hold the same stocks as the index it tracks, and in the same proportion. For example, the iShares Core S&P/TSX Capped Composite Index ETF (XIC) seeks to replicate the performance of the S&P/TSX Capped Composite Index. Essentially, you’d own the entire Canadian stock market!
Three big reasons why ETFs are popular among investors:
- They don’t require as large of a skillset as active investing.
- As a result of the above, ETFs have much lower fees attached.
- Between 2009-2017, the North American markets yielded tremendous results. For example, the S&P 500 returned ~15% on an annualized basis.
Passive investing strategy
Passive investing, as mentioned above, is all about the long game. A cost-effective ‘buy-and-hold’ approach sees gradual returns, relying on the market’s ability to get there over time. It’s historically been an approach many investors go for, including noted legend Warren Buffett, who has repeatedly given the same one-liner advice: “Put 10 percent of the cash in short‐term government bonds and 90 percent in a very low‐cost S&P 500 index fund.“
The pros and cons of passive investing
- Lower cost: Given the lack of complexity in product structure, ETFs have a much lower cost.
- Lower risk: Index funds and ETFs have diversification baked-in, since they contain a mix of asset classes and industries.
- Tax minimization: Considering that investments are held for an extended period of time, passive investing minimizes investment-related tax implications associated with buying and selling securities.
- Lack of downside protection: While by mimicking market returns, passive investing can generate marvelous results in an upward market, on the other hand, the strategy does not provide protection to investors when markets take a turn for the worse.
What is active investing?
The main objective of active investing is to generate higher returns than the market/benchmark that it follows. This excess return is known as alpha.
Simply put, active investing is achieved through stock picking. An individual investor or investment manager researches, identifies, and invests in stocks they believe will outperform the broad market. It’s all about the hands-on approach and taking advantage of short-term fluctuations.
For example, an active investment manager may select only 30 stocks of the 500 in the S&P 500 index. These will be stocks that their research has identified to be the 30 stocks that will produce a better return than investing in all of the 500 stocks. As a result, the portfolio no longer has the same stocks and their respective weights as the index. The process of active investing requires great skills, such as performing macroeconomic and industry research, analyzing the financial statements of a company, and forecasting its financial health.
The pros and cons of active investing
- Flexibility to deploy a wide range of strategies: Active investing provides the investor/portfolio manager with the flexibility to deploy a wide range of strategies in order to beat the market/benchmark it follows. Aside from overweighting undervalued stocks and underweighting overvalued stocks, the portfolio manager can use complex strategies such as short selling, leverage, and derivative strategies.
- Potential to outperform the market: Through active selection of stocks that are expected to beat the market, active investing provides an opportunity for an investor’s portfolio to outperform the index. Furthermore, active management allows investors to be exposed to various investment vehicles that are not currently available via passive investing.
- Ability to engage in downside protection: Through various strategies, the portfolio manager is able to engage in downside protection when markets take a turn for the worse.
- Higher cost: As a result of the effort required in the strategies employed, active investing products are generally offered at higher fees than passive products.
- Potential to underperform the market: Active investing strategies have the potential to underperform the market during positive or negative market swings.
- Risk: There is a tremendous amount of risk in stock selection. To be blunt: when you’re right, you’re right, but when you’re wrong, oh boy — you could be very, very wrong.
So, when looking at active vs. passive investing — which strategy is a better option? That depends.
In fact, the two strategies can efficiently coexist in one’s portfolio. A passive strategy would allow you to reap the benefits of an upward market. At the same time, active investing means you can enjoy downside protection and partake in the opportunity to outperform the market. Ultimately, when looking at active vs. passive investing, it’s about your financial goals.
At Wealth Management Canada, we believe that a great active investment manager can and will outperform the market over the long term. However, in situations where an investor is unable to work with a top active firm, passive investing is a very popular route to take. In the end, it’s a better option than working with an active manager who can’t deliver alpha.
To some of us, the world of investing feels complex and overwhelming through its various terms and strategies. As a result, you might feel uneasy when navigating the wealth management space. If you can relate, take a moment to remind yourself that finance is not unique in this way. Whether it’s technology or gardening it takes time to learn and familiarize yourself with a topic. If you have a wealth manager, be sure to ask them plenty of questions. A great manager will be able to carefully answer these and explain additional information in a clear way.