Active Vs. Passive

Posted by Touchstone UK on

This topic is as old as retail investing itself. Does an actively managed fund really deliver the premium returns that warrant the additional expense.

To start on a negative note for active investing here is an article from the New York Times which points out that in the five years to 2022 not one of 2,132 mutual funds beat the market consistently for a five year period.

Despite the above it is essential to weigh up the pro’s and cons –

Pro’s and Con’s of Active Investing

Passive Investing Advantages

Some of the key benefits of passive investing are:

  • Ultra-low fees: No one picks stocks, so oversight is much less expensive. Passive funds simply follow the index they use as their benchmark
  • Transparency: It’s always clear which assets are in an index fund.
  • Tax efficiency: Their buy-and-hold strategy doesn’t normally result in capital gains taxes due

Passive Investing Disadvantages

Proponents of active investing would say that passive strategies have these weaknesses:

  • Too limited: Passive funds are limited to a specific index or predetermined set of investments with little to no variance; thus, investors are locked into those holdings, no matter what happens in the market.
  • Small returns: By definition, passive funds will pretty much never beat the market, even during times of turmoil, as their core holdings are locked in to track the market. Sometimes, a passive fund may beat the market by a little, but it will never post the significant returns active managers crave unless the market itself booms.
  • Reliance on others: Because passive investors generally rely on fund managers to make decisions, they don’t specifically get to say in what they’re invested in.

Pro’s and Con’s of Active Investing

There are also several strengths and weaknesses of active investing.

Active Investing Advantages

Advantages to active investing:

  • Flexibility: Active managers aren’t required to follow a specific index. They can buy those “diamond in the rough” stocks they believe they’ve found.
  • Hedging: Active managers can also hedge their bets using various techniques often not available in passive strategies such as short selling.
  • Tax management: Even though this strategy could trigger a capital gains tax, advisors can tailor tax management strategies to individual investors, such as by selling investments that are losing money to offset the taxes on the big winners.

Active Investing Disadvantages

But active strategies have these shortcomings:

  • Cost: The average expense ratio at 0.68% for an actively managed equity fund, compared to only 0.06% for the average passive equity fund.
  • Active risk: Active managers are free to buy any investment they believe meets their criteria
  • Management risk: Fund managers are human, so they can make costly investing mistakes.

Listing the above I think their are other things to consider on a more localized basis. For example the stock markets of India and the US are hugely different, with the US being much more mature as a stock market with many decades of existence, high amounts of regulation and oversight and a huge investor base. Compare that to India whose main NSE index is only 32 years old and the picture is quite different. If you were looking to put a significant investment into Indian stocks I think it could strongly be argued that using an active manager with ‘boots on the ground’ and a team of analysts reviewing individual stocks makes a lot more sense than putting it into a tracker.

Ultimately it depends on the individual and whether or not they see value in a team of professionals constantly reviewing a fund or whether they feel ‘Mr. Market’ is the best person to help. Furthermore it always make sense to sit down with a financial professional to run through your own personal thoughts on this and review the options that fit your risk profile.