Passive and Active Investing

On 10/22/2010, in Investment Strategies, Mutual Funds, by Jordan Wilson

We will look at the active versus passive management debate.

Today we shall differentiate the two strategies.

Then we shall shall see if one strategy is preferable when investing.  

Passive Investing

Passive investing is quite straightforward.

Match the Market

The underlying belief is that investors cannot beat the market.

Passive investors believe that the markets are highly efficient. That is, the current price of a security reflects all information concerning the issuer so securities always trade at their fair value. Therefore, it is not possible to outperform the market over the long-term through fundamental or technical analysis, nor other active investment strategies.

As passive investors believe they cannot beat the market, they do not try. Instead, they simply attempt to replicate the market by investing in index mutual or exchange traded funds (ETF) that mirror the benchmarks they wish to track. One can also use advanced strategies to replicate benchmarks. These normally involve the use of derivatives.

The market will be normally be a benchmark index or composite indices that reflect the fund’s or investor’s investment style.

For example, Standard & Poor’s (S&P) 500 may serve as a suitable proxy for a large-cap U.S. domestic fund. Or for investors wishing to compete against the entire U.S. equity market, the Wilshire 5000 Total Market Index may be an appropriate benchmark.

Minimal Trading

Passive investing also takes a passive approach to trading. One buys the index and holds it. There may be some activity within the investment itself as securities are added and dropped from the benchmark over time.

For example, on August 26th, 2010, Tyco International (TYC) was added to the S&P 500. As the index only contains 500 companies, Smith International was dropped. If your fund fully replicated the S&P 500, it would have to sell its holdings in Smith and buy shares of Tyco.

Or, as the passive investor’s circumstances change, he may add or subtract from his holdings in the index fund.

Perhaps an investor wants to hold 50% in a global equity index fund and 50% in a global bond index fund. Over time the equity fund does very well and after two years the portfolio ratio is 70% equities and 30% bonds.

If the investor still desires a 50-50 split, he will have to rebalance the portfolio by selling some of the equity fund and purchasing additional shares of the bond fund.

Minimize Costs

In passive investing, cost control is paramount.

It is possible to invest in assets that closely match a benchmark’s gross returns. But each dollar spent on commissions, loads, management fees, and other expenses, will erode the net returns of your investment versus the no-cost benchmark.

Be very careful when planning to invest in an index fund or ETF. Always compare costs to ensure that you are getting the most return you can.

Active Investing

Active investing is the opposite of a passive strategy.

Beat the Market

Investors believe that markets are not totally efficient. As a result, by actively using different investment strategies and tactics investors can outperform the market or relevant benchmark index. Strategies and tactics may involve the use of securities’ selection, market timing, and more complex trading techniques and investment options.

In selecting specific securities, investors may use fundamental or technical analysis. Investors are trying to find securities that are not trading at their “correct” value based on their analysis. By investing in these assets and ignoring other components on the benchmark index that are considered correctly or over-priced, investors can outperform the benchmark.

Lots of Trading

While a passive strategy is one of buying and holding, active management may trade extensively.

Trading may result from security analysis as the portfolio replaces expected lower performing assets with ones anticipated to have higher relative returns.

Trading may also result from market timing activities, another staple of active management.

Market timing involves identifying trends in the general market or market segments that are deemed favourable or unfavourable. Then, shifting assets into or out of the segments to take advantage of the prevailing conditions.

For example, the S&P 500 holds 500 large-cap American companies. Unless specific company conditions necessitate additions or deletions from the index, the companies remain the same.

However, what if the U.S. economy enters an economic slowdown? It may be prudent to shift one’s assets into more defensive stocks that can better weather a recession. An active investor will sell his cyclical stocks and replace them with recession-resistant investments. The passive investor does not do this; he must ride the tide.

Or perhaps the precious metals market is expected to significantly outperform the overall market while healthcare is expected to do relatively poorly. If you own a fund that reflects the S&P 500, you will be forced to hold companies such as Abbott Laboratories, Aetna Inc, Cerner, Life Technologies, Wellpoint Inc., etc. Whereas, the active investor might sell most of these healthcare companies and replace them with non-S&P 500 holdings like Agnico-Eagle Mines, Barrick Gold, Rio Tinto, etc.

Complex Tactics

Active investors often use leverage, derivatives, and short selling to try and outperform the benchmark index which does not incorporate these techniques.

These tactics are outside the scope of our discussion right now, so I simply mention them in passing.

Net Returns Not Cost Control

Active investors realize that they will incur greater costs than by using a passive strategy.

As they believe they can outperform the market, the concern is more the net returns rather than cost control.

For example, say that the S&P 500 returned 10.0% over the last year. A passive strategy that replicates the S&P 500 index may have a total expense ratio of 0.10%. If the fund properly duplicates the benchmark index,  the net return under the passive strategy is 9.9%.

An active fund that uses the S&P 500 as a benchmark may have a total expense ratio of 1.5%. Significantly higher than the passively managed fund. But investors believe that management performance will more than offset the extra expenses.

But does active management does provide enough extra returns to justify the higher costs?

That is the question we will consider next.

2 Responses to “Passive and Active Investing”

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