Active vs Passive Investing
These two different styles of investing have divided opinion within the financial world for many years, but what do they actually mean? Active and Passive investing may be concepts you have heard of before but never fully understood. This guide aims to help with that using explanations, advantages, disadvantages and a real-world analogy. This topic is particularly important if you are considering investment advice.
Setting the scene
Before we begin, let’s define what we mean by investing in this context. Investing refers to the purchase of financial assets such as stocks, shares and bonds, with the purpose of making money. When we talk about ‘the market’, this means the general prices of these financial assets. As we know, these prices can go up or go down. It is true to say that over the long-term (20+ years) the trend has been upwards, but there were many fluctuations along the way.
To demonstrate this, we will take a closer look at the UK stock market. You may have heard of the FTSE 100 index – this contains the top 100 companies on the UK stock market. Companies such as AstraZeneca, Barclays and Sainsburys feature on this index. The below graph and table show the % growth that the FTSE 100 has experienced each year since 2015. This shows that even though the overall value has grown since 2015, it has been a bumpy ride to say the least! If the stock market constantly rose, there would be no need for investment managers, and it is a multi-billion-pound industry!
Within the vast world of investing, there are billions of investors who all have the same goal. Every investor is looking to make money. How they go about this, however, varies greatly. There are many possible approaches but the two most well-known are active and passive. It is worth noting that blending these two strategies is possible and very common, but this guide focusses on them separately.
Active Investing
As the name suggests, active investing involves taking lots of actions. These are in the form of frequent buying and selling of assets to take advantage of changes in the market. Active investors are of the belief that through research and analysis, they can achieve higher % growth than if they simply purchased every stock and held them in the long-term. Their theory is that the current market prices do not fully reflect all information available, so by digging for information, they can gain a better understanding of those stocks that are undervalued, and those that are overvalued.
This does not necessarily mean that active investors claim to be fortune tellers. If any active investor tells you they predicted the Coronavirus pandemic and sold their assets before the market crashed, they are most likely lying, or possibly started the pandemic themselves! Through their research, active investors look to find clues that increase the probability of them making more money. The idea is similar to counting cards in blackjack (a ‘frowned upon’ strategy in blackjack that is controversially used by gamblers to make large profits). Counting cards doesn’t guarantee that you win every round, but it moves the odds of you winning in your favour rather than the dealer’s.
What is an example of active investing?
The strategy of active investing relies on the investor being right more times than they are wrong. If this is the case then they are likely to achieve their goal of ‘outperforming the market. To demonstrate what we mean by this, let’s go back to the FTSE 100 example.
An active investor focusing on FTSE 100 companies would aim to exceed the % returns quoted in the table by buying and selling certain stocks at different times. In this case, they would consider the FTSE 100 index their benchmark. A benchmark is used to compare performance against to judge how effective a particular fund has been. In the FTSE 100 example, instead of holding most or all of the company stocks from 2015 to present day, they may believe (through their research) that in 2017 AstraZeneca is likely to go through a difficult period, whilst the outlook for Sainsburys is far brighter. Therefore, they would sell some or all of their AstraZeneca holdings and buy some shares in Sainsburys.
One of the main difficulties with this strategy comes when looking at the costs involved. It is not free to keep buying and selling stocks, and if you are using an active fund manager, their (probably high) salary needs to be factored in. Most will have a team of analysts behind them as well. In 2018, a study showed that the average annual cost of an active equity fund (collection of stocks managed actively) is 0.76%, while the average for the passive equivalent was only 0.08%.
That cost difference of 0.68% may not sound like much, but the effect it has over time is significant. If you invested £10,000 into the two funds (one active and one passive), and they both achieved 5% growth every year, then the effect of the higher costs would be as follows:
Considering this, the pressure is then on the active manager to ‘outperform the market’ sufficiently so that the additional costs are returned through higher growth. That said, the cost of active investing is becoming lower so the gap to passive costs is narrowing all the time. There will be a limit to how low the charges can go, but any reduction will go a long way to convincing the doubters that active investing is favourable compared to passive.
Is active investing worth it?
Active investing involves frequent buying and selling of financial assets with the aim of ‘outperforming the market’. Thorough research and analysis is undertaken in order to get the timing of these trades correct.
Advantages
- Decisions taken by industry experts
- Flexibility to change depending on current market conditions
- Potential to ‘outperform the market’
Disadvantages
- High costs
- Not always clear which assets are owned at any one time
- No guarantee of higher returns
Passive Investing
Passive investing seeks to match the market rather than outperform it. The belief is that owning a diversified range of assets within a particular market will give consistent returns in the long-run, and at a much lower cost. There is very little buying and selling activity involved, and stocks will be bought and held for a long period of time. Sometimes it can be challenging to maintain this strategy, for example during times when prices have fallen significantly. The temptation is to sell before it gets worse, but the strategy requires a buy and hold mentality.
What is an example of passive investing?
Passive funds (collection of stocks passively managed) generally look to follow a particular index, like the FTSE 100 index for example. These funds will buy and hold most or all of the stocks within the index so that if the index performs well, so does the passive fund. They are attractive because of their very low costs, especially compared to the cost of buying each individual stock separately.
In contrast to active investors, passive investors are of the opinion that market prices reflect all the information available, and therefore additional research and analysis can not give an advantage. This idea is known as markets being efficient.
Statistically, passive funds have performed better than active funds after taking into account the additional costs of investing. Many active funds have outperformed the market but not by enough to make up for their high charges. However, many active fund managers will still claim that they have consistently exceeded their benchmark. Believers of the passive approach would argue that this may be possible in the short-term, but since markets are efficient, those gains will be balanced out with underperformance at some stage.
The main criticism associated with passive investing is that the chances of exceeding the returns of the chosen index are extremely low. It is not a glamorous option and in difficult market conditions appears to accept poor performance whilst relying simply on time to turn things around. Furthermore, as passive funds follow an index, it is difficult to gain access to specialist investment markets. There are only so many indexes in the market, so it is mostly active fund managers that offer an exposure to the more niche areas of the economy. An example of this is that passive ESG funds (find out more about ESG investing here) are generally not considered to be as positive for society compared to active ESG funds. Active fund managers have more ability to exclude companies that have a negative impact and include companies driving for positive change.
Going back into history, the first passive index fund was made by John Bogle, founder of the investment firm Vanguard. This was created in 1976 and tracked the US S&P 500 index, so he named it the Vanguard 500 fund. John’s philosophy was to use low cost funds that mimic the general market, rather than trying to beat it. He believed that long term investing reduced the need for speculation and could therefore achieve better returns for those with a long time horizon, especially when accounting for the reduced costs of investing. At first, he was ridiculed by industry experts because this theory was unheard of and active investing was the norm. By the time he died, however, he was praised as the ‘father of indexing’. Famous investing billionaire Warren Buffet even said that “John did more for American investors as a whole than any individual I’ve known”. Today, the passive investing industry is worth over $10tn.
Is passive investing good?
Passive investing is a strategy of buying and holding. The main aim is to match the returns of a chosen index, for example FTSE 100 index.
Advantages
- Low cost
- Transparency in which stocks owned
- Easy access to diverse range of stocks
Disadvantages
- Unlikely to exceed general market returns
- Generally limited to indexes, with little access to specialist investments
- Does not react to market changes
What is the difference between active and passive investing?
Hopefully you now feel like you understand these concepts a whole lot better than at the start of the guide. This real-world analogy should cement your knowledge and how it applies in the investing context:
- Imagine that two cars are racing from one side of London to the other. The car that gets to the finish line first is the winner (achieved higher % growth), but there are time penalties for fuel consumption (investing costs). It is a busy day on the roads so there is lots of traffic (stock prices rising and falling).
- One car is a flashy red Ferrari (active investor), and the second an everyday use Ford Fiesta (passive investor).
- Driving the Ferrari, we have an experienced racing driver, an expert in their field (active fund manager). And in the Ford sits an average driver who is safe, reliable, but by no means a racer (passive fund manager).
- During the race, the Ferrari (active) is weaving in and out of lanes (buying and selling stocks) and trying to find the gaps in the traffic (nuggets of information) to gain an advantage in the race.
- Meanwhile, the Ford (passive) is content staying in their lane, happy in the belief that whilst one lane may be faster at some points (companies outperforming others at various stages), they will balance out in the long-run.
- Both cars reach the finish line (higher % growth) at a similar time, with the Ferrari slightly in front. However, the Ferrari has used more fuel whilst changing lanes and speeding into gaps (cost of constant buying and selling of stocks).
Which one is the real winner? That is the big debate surrounding active vs passive investing.
Glossary
- Investing - the purchase of financial assets such as stocks, shares, bonds with the purpose of making money
- Fund - a collection of individual assets. It is possible to have funds of funds, that contain a collection of funds. A fund could be specific to certain industries, for example pharmaceutical companies. A fund could also have a mix of bonds and shares.
- Index - this is a subset of an equity market that can be used to compare to when analysing investment performance. One example is the FTSE 100 index, which holds the top 100 companies in the UK. The FTSE 250 index holds the next 250 largest companies, so those ranked from 101-350.
- Market conditions - this describes the current factors that affect the stock market. In a time of economic difficulty such as 2008 or in 2020 during the pandemic, it would be correct to say the market conditions were poor. Strong market conditions would suggest companies and investments will thrive during a given period.
- Bonds - these are financial assets where you effectively lend money to the issuer of the bond. This would usually be a company or the government. A fixed amount of interest is given during the period that the bond is held, and then the initial money is returned at the end.
