Active vs Passive Investing: What’s Better?

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Active investing is when you buy and sell financial securities in an attempt to maximize profits and create a balanced portfolio that reflects your risk aversion. Day trading of stocks, bonds, commodities and derivatives, is considered active investing. However buying shares of a mutual fund that compensates portfolio managers for “picking stocks” on your behalf and constantly balancing the portfolio, is also considered active investment.

Passive investments on the other hand are investment funds that track indices, which are bundles of securities that have been grouped together because they fit specific criteria. For example, the S&P 500 is an index that includes the 500 largest U.S companies  listed on the NYSE or NASDAQ. Exchange-traded funds (ETFs) are also considered passive investments because they  track indices and other basket of securities.

Passive investing has become very popular over the last decade, with trillions of dollars being transferred from the mutual fund industry. Amateur investors have become very fond of ETFs and index funds because of the low transaction and management fees and the security mix that provides some risk diversification. However Mutual funds companies will tend to argue that their expertise in portfolio construction and diversification is worth paying for.

So should you hire an active manager to oversee your assets? Or should you handle the investing yourself with ETFs and/or a ‘set-and-forget’ passive strategy? The answer to this question is not definitive, and it really depends on what type of investor you are. It may also, interestingly, depend on when you’re trying to decide. But more on that later.

When To Favour Active Investing

If you’re the type of investor who:

  • Wants alpha (i.e. you want to outperform the market);
  • Wants tactical management during economic downturns;
  • Tends to get emotional during volatile periods;
  • Wants a professional advisor you can talk to and work with…

Then active management is probably the right choice for you. But seeking out an active manager doesn’t mean you’ll always get those things—not all active managers are created equal. In fact, a well-known academic study of a 20-year period from 1990 through 2009 looked at returns of active managers relative to their respective benchmarks, and found that net of fees, the active managers underperformed by about 40 basis points per year. Interestingly, the study concluded that in periods when equity-market returns were 10% or higher, only about 30% of active managers outperformed their benchmarks.

So, at this point you may be thinking, why hire an active manager at all? Two reasons. First is that when the researchers looked closer, they found that truly active managers actually performed quite well. The most active 20% of managers, which the study called “diversified stock pickers,” outperformed their benchmarks by 126 basis points per year. The key takeaway here for investors is that active managers who actually trade regularly and have proven track records may be the ones to seek out.

The second reason is that active managers tend to thrive in tighter markets, when returns are subdued and there’s not much alpha out there to be had. In periods when market returns were under 10%, over 50% of active managers outperformed.

That’s why I mentioned earlier that it might matter when you’re asking about whether active is better than passive. In an environment when market returns looking forward are expected to be low – perhaps such as now given we are nine years into the bull market and valuations are stretched – then active managers could deliver.

When To Favour Passive Investing

If you’re the type of investor who:

  • Is truly focused on the long-term;
  • Has the patience to shrug off volatile swings and stay cool in difficult market environments;
  • Is fee sensitive;
  • Can keep your emotions in check;
  • Is ok performing in-line or slightly lower than the market…

Then passive investment is probably the right choice for you. With active management, there’s always a chance that the manager you hire will let you down, underperform the market, and mistime/mismanage a market downturn (or upturn). With passive management, your portfolio tracks the ups and downs of the market, and you participate in just about every price swing.

At its core, passive investment means purchasing an ETF that tracks an index, such as the S&P 500. For an investor who is truly passive, there is only one action item to take: purchase an ETF that tracks the index and never sell it. Over very long stretches of time (20+ years), the S&P 500 has proven to deliver attractive returns, the question is whether the passive investor can manage not to abandon the strategy in the heat of a bear market. That’s where “patience” and keeping emotions in check is critical.

Are You an Active or Passive Investor? 

In reality, most investors are active investors. We have too much desire to outperform, and are driven all too often by new investment ideas and attractive trades. It’s human nature. Perhaps the key is to be an active investor who also removes emotion completely from the equation, so you avoid unnecessary mistakes. You can do that by hiring an investment manager or using Artificial Intelligence (Robo-Advisors) to help you manage your portfolio over time. Platforms such as tickeron.com provide such services.

Did this help? Your opinion matters. You can rate this article, leave a comment below or share it on social media. Follow Bobbyfinance for more financial tips.

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