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Active Investing versus Passive Investing

Investment

Active vs Passive Investing

These two different investing styles have divided opinion within the financial world for many years, but what do they 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 critical 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 down. It is true 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 closely examine the UK stock market. You may have heard of the FTSE 100 index, which contains the top 100 companies on the UK stock market. Companies such as AstraZeneca, Barclays and Sainsbury are featured on this index. The below graph and table show the % growth that the FTSE 100 has experienced each year since 2015. This indicates 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: 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 focuses 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 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 better understand stocks that are undervalued and 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 likely lying or possibly started the pandemic themselves! Through their research, active investors look to find clues that increase their probability of 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 often than wrong. If this is the case, they are likely to achieve their goal of outperforming the market. Let’s go back to the FTSE 100 example to demonstrate what we mean by this.

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 as their benchmark. A benchmark compares performance against 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 the present day, they may believe (through their research) that in 2017, AstraZeneca is likely to go through a difficult period, whilst the outlook for Sainsbury is far brighter. Therefore, they would sell some or all of their AstraZeneca holdings and buy some shares in Sainsbury’s.

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) was 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 its effect 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 decreasing, so the gap to passive costs always narrows. 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 to outperform the market. Thorough research and analysis are undertaken to determine the timing of these trades.

Advantages

  • Decisions taken by industry experts
  • Flexibility to change depending on current market conditions
  • Potential to ‘outperform the market’

Disadvantages

  • High costs
  • It is 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. Minimal buying and selling activity is involved, and stocks will be bought and held for an extended period. It can be challenging to maintain this strategy, for example, when prices have fallen significantly. The temptation is to sell before it worsens, but the approach requires a buy-and-hold mentality.

What is an example of passive investing?

Passive funds (a collection of stocks passively managed) generally follow a particular index, like the FTSE 100 index, for example. These funds buy and hold most or all of the stocks within the index, so if the index performs well, so does the passive fund. They are attractive because of their meagre costs, especially when buying each stock separately.

In contrast to active investors, passive investors believe that market prices reflect all the information available; 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 considering 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 challenging market conditions, appears to accept poor performance whilst relying simply on time to turn things around. Furthermore, as passive funds follow an index, gaining access to specialist investment markets is difficult. There are only so many indexes in the market, so primarily active fund managers offer exposure to the more niche areas of the economy. An example is that passive ESG funds (find out more about ESG investing here) are generally not considered favourable for society compared to active ESG funds. Active fund managers can exclude companies with a negative impact and include companies driving for positive change.

Going back into history, John Bogle, founder of the investment firm Vanguard, made the first passive index fund. 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 try to beat it. He believed that long-term investing reduced the need for speculation and could 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. However, by the time he died, he was praised as the ‘father of indexing’. Famous investing billionaire Warren Buffett said, “John did more for American investors than any individual I’ve known”. Today, the passive investing industry is worth over $10tn.

Is passive investing good?

Passive investing is a buying and holding strategy. The main aim is to match the returns of a chosen index, such as the FTSE 100 index.

Advantages

  • Low cost
  • Transparency in which stocks owned
  • Easy access to a 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 understand these concepts much better than you did at the start of the guide. This real-world analogy should cement your knowledge and how it applies in the investing context:

  • Imagine two cars 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 are rising and falling).
  • One car is a flashy red Ferrari (active investor), and the second is an everyday-use Ford Fiesta (passive investor).
  • In the Ferrari, we have an experienced racing driver, an expert in their field (active fund manager). In the Ford, we have an average driver who is safe and reliable but by no means a racer (passive fund manager).
  • During the race, the Ferrari (active) weaves in and out of lanes (buying and selling stocks) and tries to find gaps in the traffic (nuggets of information) to gain an advantage.
  • Meanwhile, Ford (passive) is content staying in its lane, happy in the belief that while one lane may be faster at some points (companies outperforming others at various stages), it 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 while changing lanes and speeding into gaps (the cost of constant stock buying and selling).

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, and bonds with the purpose of making money
  • Fund – a collection of individual assets. It is possible to have funds that contain a collection of funds. A fund could be specific to certain industries, such as 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 compared 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 describe the current factors that affect the stock market. In a time of economic difficulty, such as in 2008 or 2020, during the pandemic, it would be correct to say the market conditions were poor. Strong market conditions would suggest that companies and investments will thrive during a given period.
  • Bonds are financial assets in which you lend money to the bond issuer, usually a company or the government. When the bond is held, a fixed amount of interest is paid, and the initial money is returned at the end.

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