Active vs Passive Investing

For anyone in the know about investing, you likely appreciate that it was only a matter of time before I wrote and article on active vs passive chosen style of investing.  This has been a raging debate for countless years, with some investors staying absolutely loyal to their chosen style of investing through thick and thin.  But what are these two styles of investing?  Where should you sit on the active vs passive investing spectrum?

What is Active Investing?

The majority of investments that you likely come across in day to day life (other than shares, which are neither active nor passive) are probably active in nature.  This is based on the idea that most people will probably have their company pension – most of which operate a range of active investments possibly supplemented by a handful of passive funds – and perhaps an ISA with a fund supermarket and active funds still make up the majority of the investment universe.  If you have ever heard of an Exchange Traded Fund (ETF) you are likely in the minority just for that, let alone if you actually use one.

Active Investment is about analysing the constituents of an investment market and trying to work out which shares, bonds or other instruments offer good value and which do not.  The goal then is to buy more of the assets which are favourably priced and to stay away from those that are expensive – or to sell them if they are already in the portfolio.  In exchange for this, the management team levy a charge, usually a percentage fee, and the hope is that in the long run this fee is worth paying  for the expertise that you get from the team.

Common received wisdom is that management teams operating investment funds should be able to squeeze enough additional performance out of the investment portfolio to offset their fee, either by achieving greater returns during positive years for the market or by minimising the losses incurred during years of economic stress.

Unfortunately life is not that simple.  We all know that buying low and selling high is a good financial move, but the  practicality of doing so is much harder.  Identifying when a stock is overpriced doesn’t tell us anything about the short term prospects for that stock – it could continue to go up in defiance of economic sense, or it could crash down to where it is “supposed” to be in the next couple of weeks.

Some management teams will try to focus on something different as a goal, for example provision of a steady income stream.  This changes the nature of the investment somewhat, and can make it a lot harder to directly compare their performance to a market or to economic conditions, but it is a necessary part of the investment world to have funds with different goals.

What is Passive Investing?

While Active Investing values expertise in analysing companies, Passive Investing goes the other way and argues that no amount of analysis can squeeze out enough of a return to warrant the fees associated with active management.  Rather, a Passive Management strategy involves buying up the constituents of a particular investment market and then riding out the market movements whenever they happen.  This is a very low-cost approach for the managers, and as a result they usually only levy a low annual management fee on their funds.

Received wisdom again comes into play, claiming that Passive Investments generally return about the same in the long run as Active Investments with similar focuses (foci just sounds pretentious!) but that the short term volatility (the up and down movement of the price of the assets) is higher because there isn’t a human element looking to minimise the risk.

In recent years there has been a huge increase in the range of passive instruments, with traditional market trackers (e.g. the FTSE 100 or the S&P 500), a host of “Smart Beta” products (e.g. an Equal Weight FTSE 100 tracker) as well as a host of instruments that track a subset  of a market (e.g. UK Financials) that  can either be traditional weighting or Smart Beta in nature.  In short, the choice is now truly staggering, though you might not see the full range unless you have a specific type of investment account.

Hybrid Strategies

Just to make life even more confusing, there are now blends of these two strategies.  Typically this involves active asset allocation, which determines the exposure that the fund or strategy wants to have, followed by  passive investing to match that strategy.  This means that the management team can focus on the large scale economic issues of the day and not spend their time analysing specific company or bond valuations, therefore this should still be low cost, albeit not as low cost as a pure passive investment.

Academic Research – Active vs Passive Investing

I have mentioned a couple of times that received wisdom says something or other.  In general I  would always urge caution when dealing with received wisdom, as it can be tainted by all sorts of unconscious (or worse yet conscious) biases, which could easily make the conclusions false.  It is also worth remembering that there is a huge amount of money being paid to fund managers for providing both active and passive investment services, so there is a lot of vested interest in demonstrating the merits of either strategy.  As such, when deciding on a winner between Active vs Passive Investing, I think it is important to look at the  academic evidence put together by non-industry participants.

Unfortunately, this is often very unapproachable, and in many cases will be specific to a particular tax jurisdiction.  For example, there are a number of very detailed analyses on the US investment market, but the UK has a very  different system for things like tax treatment both of the funds themselves and the investors who hold them.  It is still worth looking into these studies if you are interested, but remember that crucial difference when drawing your conclusions.

If you are interested in the subject and would like to do a little more reading, you could definitely do worse than reading into Eugene Fama’s work on efficient markets.  For a lighter view on the difficulty of sustaining good performance in the long run, Bestinvest run an annual report called “Spot the Dog” where they examine the major investment sectors and identify funds that have grossly underperformed compared to their peers – the number of times a previous star fund falls into this dog territory shows just how difficult it is to reliably squeeze value out of an investment market.

Conclusion – Where I Stand on Active vs Passive Investing

I think the debate on Active vs Passive investing has a long life ahead of it still – it is far from a settled matter.  This is partially down to the fact that when one style is dominant there should be opportunities for the other – where most investment money is simply tracking the markets there should be opportunity for a canny investor to take advantage of market irrationalities for the benefit of their investments.  But the more people who chase after those irrationalities, the harder they will be to identify and take advantage of before a price correction takes place.  In short, both strategies continue to have merit whilst the argument continues.

In practice, I think there are specific circumstances where it makes sense to use one or the other:

• When accumulating assets, especially when making regular contributions, and where there is a long term growth goal, it makes sense to consider Passive Investment as the default strategy because you benefit from the low cost approach and pound-cost averaging (I may do an article on this in future).
• When looking to provide an income from the investment, e.g. in retirement, I think it makes sense to include an Active Investment where the manager is specifically picking out ways to provide a regular, rising income in the form of dividends or interest.
• Geographically, highly efficient markets lend themselves more towards passive investing, while inefficient ones suggest that active investing will be better.  As such, for highly developed markets like the UK and US large company indices, passive likely gets a boost in credibility, while developing markets and smaller companies offer opportunities for managers to find good deals for investment.

So, to bring a very long argument to a close – where do I stand on Active vs Passive Investment?  I’m pretty agnostic, and want to include both depending on specific goals for the investment.  I do however start from the basis that an active manager has to demonstrate why they are worth their fee compared to a passive fund – if they can’t, that’s not a manager I want to be using for either my own money or that of my clients.

And where should you stand? That’s largely going to be up to you.  In all likelihood, the biggest benefit to you will be that you are investing at all, not that you have correcting identified the winner in Active vs Passive Investing, because the evidence seems to show that, overall, there’s not as much in it as the advocates for each would like you to believe.

If you want to talk about what you’ve just read, feel free to get in touch and I’ll arrange a conversation.