Passive investing vs Active investing – How do you choose?
Introduction
Investment decisions require a lot of research and analysis to ensure that there is the right mix of investments in one’s portfolio. This will ensure the maximization of returns for the investor in the long run. Investors also have to keep in mind that the cost of investment is not too high which may eventually reduce their returns. Investors can choose many investment products based on various parameters like investment budget, returns expectation, risk factors, etc. However, broadly speaking, there are essentially two forms of making investments: active investing and passive investing.
Given below is a brief explanation about the two and the pros and cons of each mode of investments.
Active investing
Active investing is essentially when the investor uses an active investment strategy to generate higher returns. There are two ways of active investment strategy
– Investment in actively managed funds (like mutual funds) where the fund managers are the decision makers
– Investment by the investors themselves using thorough market research and analysis.
Active investing is investment in actively managed funds or stocks and securities that aims at providing maximum returns to the investors, i.e., more than the market returns. This is based on using various investment strategies and knowing when to enter and exit the market to achieve maximum returns. The risk factor in active investing is quite high and hence, the investors have to be cautious about their investments. It is usually ideal for investors having a high risk appetite. Some examples of active funds are mutual funds, leveraged funds, equity funds, etc.
Passive investing
Passive investing is a relatively safer mode of investing in the stock market. Passive investing is investments in essentially passively managed funds. These funds usually follow an underlying index or asset for their returns. Unlike actively managed funds, there is no pressure for outperforming the market and generating higher returns. The returns through passive investing are a replication of the underlying index or asset or security which the fund tracks for its performance. Some examples of passive investing are below and you can also buy on your own and hold long term.
What Passive Portfolios Look Like
Passive portfolios typically include a few different types of investments. Principal among these are index funds, mutual funds and exchange-traded funds (ETFs). Rather than select single securities like stocks or bonds, these funds seek to diversify across a number of individual holdings. As an example, a fund centered around stocks might invest in multiple equities in specific markets, like large-cap U.S. stocks or the international market. Here’s a deeper breakdown of these investments:
- Mutual funds: When you buy into one of these funds, you’re investing in a company that will buy and sell stocks, bonds and more in your name. In other words, mutual funds combine professional management and diversification.
- Exchange-traded funds: While similar to mutual funds in many ways, ETFs are traded on an exchange like a stock. They follow a collection of stocks or an index (such as the S&P 500, the MSCI Indexes and the Dow Jones Industrial Average). While ETFs can take a variety of investing approaches, they’re a bit more likely than a mutual fund to take a passive investing approach.
- Index funds: An index fund can be a mutual fund or ETF; either way, your investment will track the performance of an index. This has led many individual investors to consider adding index funds to their portfolios over ETFs. Fidelity and Vanguard claim some of the more popular index funds, such as the Vanguard Growth Index (VIGRX) and the Fidelity 500 Index (FXAIX).
ETFs and Index Funds.
What are the points to be considered while choosing active or passive investing?
Investors have to consider a few points that will help them in choosing between active and passive investment strategies. These points explain the nature of these investment strategies and help them in making better investment decisions.
a. Category of funds you are investing in
The funds that the investor’s choose for investment are based on their investment strategy. Funds like mutual funds, individual stocks or equity funds, hedge funds require active participation of the fund manager to generate higher returns than market and maximize investor’s wealth.
Funds like ETFs, index funds, fund of funds are classic examples of passive investing. These funds may not generate returns higher than the market but they are considered relatively safe and stable investments thereby making them a great addition to the investor’s portfolio.
b. Past performance
Past performance is often used as a benchmark by investors while making investment decisions. While this is an important consideration, it is not advisable to base investment decisions solely on the past performance of an investment product. Actively managed funds have recently had a tough time in generating returns higher than the market but have still managed to outperform passively managed funds in the long run.
c. Costs involved in investment
The investment budget is one of the major points of considerations that determine the investment strategy. Active investing requires the active participation of fund managers and a team of analysts that use various technical and fundamental analysis tools that help in generating higher returns for the investors. This ultimately leads to an increase in the costs of investment.
Passive investing on the other hand does not require such heavy influence of the fund managers and an extensive team of analysts for managing the investments. This has a direct influence on the cost of investments and reduces them significantly. Hence it is a better investment strategy for investors having a limited budget.
d. Control over the investment portfolio
Active investment strategy provides the investors with the benefit of choosing their investments in their portfolio. Investors can select the investments based on careful research and analysis and matching their investment horizon, investment budget risk return expectations.
Passive investing does not provide this option to the investors. The portfolio of the passively managed funds is structured based on the index, asset, or security that it tracks. The assets in the portfolio are usually in the same weightage as the index. Hence, there is no scope for customization of the portfolio which can be availed in actively managed funds.
e. Transparency in investments
Active investing provides the details of all the investments at regular intervals. However, investors may not get the details of the investment portfolio at any point in time. Passive investing on the other hand involves a portfolio of assets that have assets in the same proportion as in the underlying index it tracks. Hence the investors can be aware of their investments and the underlying assets at any point in time.
f. Ability to diverse
Diversification is one of the most important tools for investors to maximize their returns and reduce their risks. Investors in active investing strategy can pick and choose their investments across various categories and assets as well as across different sectors or industries. This gives them the advantage of healthy diversification in their portfolio leading to higher returns. The benefit of diversification is not available in the case of passive investing. Investors cannot choose or alter the assets in the underlying index. Hence, diversification in passive investing is limited to the extent of the different assets under an index or the few sectors that are part of the index.
Passive investing, which is also sometimes referred to as passive management, is best categorized as a “buy and hold” philosophy. At its core, it’s a straightforward investment approach that avoids frequent buying and selling and seeks to invest in securities likely to grow over the long term.
Consequently, passive investors are betting on steady market increases rather than trying to beat the market. This is in direct opposition to active management, which call for frequent transactions in an effort to achieve above-average returns.
Conclusion – what to choose?
As discussed above, both actively investing and passive investing have their advantages and disadvantages. Therefore, there is virtually no concept of an ideal investing strategy. This is because what may be a better investment strategy for one investor may not be for another. Hence, the most appropriate scenario may be a mix of actively managed funds and passively managed funds in one’s investment portfolio to generate maximum returns and also a cost effective investment.
FAQs1. What is a more transparent form of investing among actively managed funds and passively managed funds?
A. Securities in passively managed funds are in the same weightage as that of their underlying index. Whereas, actively managed funds are curated based on the assessment and expertise of the professional fund managers. Also, the portfolio information in passively managed funds is disclosed more frequently as compared to actively managed funds. Hence, passively managed funds are considered to be more transparent.
2. What is the expense ratio for passively managed funds?
A. The expense ratio for passively managed funds is relatively lower than actively managed funds which are more or less up to 1%.
3. Which funds are more tax efficient?
A. Passively managed funds are usually considered to be more tax efficient as compared to actively managed funds.
4. What is the ideal portfolio of investments for an investor?
A. The most ideal portfolio for an investor is a correct mix of actively managed funds and passively managed funds to maximize the returns at relatively lower risk and expenses.
Passive investing is an investment strategy to maximize returns by minimizing buying and selling. Index investing is one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time. Passive investing can be contrasted with active investing.
Key Takeaways
- Passive investing broadly refers to a buy-and-hold portfolio strategy for long-term investment horizons with minimal trading in the market.
- Index investing is perhaps the most common form of passive investing, whereby investors seek to replicate and hold a broad market index or indices.
- Passive investment is less expensive, less complex, and often produces superior after-tax results over medium to long time horizons when compared to actively managed portfolios.
Understanding Passive Investing
Passive investing methods seek to avoid the fees and limited performance that may occur with frequent trading. The goal of passive investing is to build wealth gradually. Also known as a buy-and-hold strategy, passive investing means purchasing a security to own it long-term. Unlike active traders, passive investors do not seek to profit from short-term price fluctuations or market timing. The market posts positive returns over time is the underlying assumption of passive investment strategy.
Passive managers generally believe it is difficult to out-think the market, so they try to match market or sector performance. Passive investing attempts to replicate market performance by constructing well-diversified portfolios of single stocks, which if done individually, would require extensive research. The introduction of index funds in the 1970s1 made achieving returns in line with the market much easier. In the 1990s,2 exchange-traded funds, or ETFs, that track major indices, such as the SPDR S&P 500 ETF (SPY), simplified the process even further by allowing investors to trade index funds as though they were stocks.
Passive Investing: What It Is and How It Works
Passive Investing Benefits and Drawbacks
Passive investing is a long-term strategy for building wealth by buying securities that mirror stock market indexes and holding them long term. It can lower risk, because you’re investing in a mix of asset classes and industries, not an individual stock.
What is passive investing?
Passive investing is an investing strategy that involves buying and holding investments for a long period of time, rather than making frequent trades to try to beat the market. It is a go-to strategy for long-term investors because it capitalizes on the typical upward trend of the overall market over many years, which tends to be favorable. Minimizing trades also ensures that transaction costs are as low as possible. Consider speaking with a financial advisor if you’re trying to decide how to take a more active approach to managing your investments.
To understand passive investing, think of the saying, “slow and steady wins the race.”
Passive investing is a long-term strategy for building wealth by buying securities that mirror stock market indexes, then hold them long term.
“And the goal of you investing this way is that you basically want to replicate the returns of that particular market index,” says Rianka R. Dorsainvil, a certified financial planner and co-founder and co-CEO of 2050 Wealth Partners, based in Upper Marlboro, Maryland.
Like fine wine, the longer you hold your investments, the longer they have to mature and give you decent returns.
It’s a popular type of investing. According to a 2021 Gallup Investor Optimism Index, 71% of U.S. investors surveyed said passive investing was a better strategy for long-term investors who want the best returns. Of those surveyed, only 11% said “timing the market” was more important to earn high returns. A majority — 89% — said “time in the market” was more important.
Maintaining a well-diversified portfolio is important to successful investing, and passive investing via indexing is enables investors to achieve diversification. Index funds spread risk broadly in holding a representative sample of the securities in their target benchmarks. Index funds track a target benchmark or index rather than seeking winners. Thus, they avoid constantly buying and selling securities. As a result, they have lower fees and operating expenses than actively managed funds.
An index fund offers simplicity as an easy way to invest in a chosen market because it seeks to track an index. There is no need to select and monitor individual managers, or chose among investment themes.
However, passive investing is subject to total market risk. Index funds track the entire market, so when the overall stock market or bond prices fall, so do index funds. Another risk is the lack of flexibility. Index fund managers usually are prohibited from using defensive measures such as reducing a position in shares, even if the manager thinks share prices will decline. Passively managed index funds face performance constraints as they are designed to provide returns that closely track their benchmark index, rather than seek outperformance. They rarely beat the return on the index, and usually return slightly less due to operating costs.
Some of the key benefits of passive investing are:
- Ultra-low fees: There’s nobody picking stocks, so oversight is much less expensive. Passive funds 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 typically result in a massive capital gains tax for the year.
- Simplicity: Owning an index, or group of indices, is far easier to implement and comprehend than a dynamic strategy that requires constant research and adjustment.
Proponents of active investing would say that passive strategies have these weaknesses:
- Too many limitations: 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.
- Smaller potential 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 big returns active managers crave unless the market itself booms. Active managers, on the other hand, can bring bigger rewards (see below), although those rewards come with greater risk as well.
Fees for funds vary. Actively managed funds typically have higher operating costs than passively managed funds, but it is always important to check fees before choosing an investment fund.3
Active Investing: Benefits and Limitations
To contrast the pros and cons of passive investing, active investing also have its benefits and limitations to consider:
- Flexibility: Active investors 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 such as short sales or put options, and they’re able to exit specific stocks or sectors when the risks become too big. Passive investors are stuck with the stocks that the index they track holds, regardless of how they are doing.
- 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.
But active strategies have these shortcomings:
- Very expensive: Fees are higher because all that active buying and selling triggers transaction costs, not to mention that you’re paying the salaries of the analyst team researching equity picks. All those fees over decades of investing can kill returns. In 2020, the average fee for actively managed mutual funds was 0.71% while fees for passively managed funds were an average of 0.06%. 4
- Active risk: Active managers are free to buy any investment they think would bring high returns, which is great when the analysts are right but detrimental when they’re wrong.
- Poor track record: The data show that very few actively managed portfolios beat their passive benchmarks, especially after taxes and fees are accounted for. Indeed, over medium to long time frames, only a small handful of actively managed mutual funds surpass their benchmark index.
How can you start passive investing?
Purchasing an index fund is a common passive investment strategy. Index funds are designed to mirror the activity of a market index, such as the Russell 2000 Index.5 Index funds are designed to maximize returns in the long run by purchasing and selling less often than actively managed funds.
Exchange-traded funds (ETFs) are another common choice for passive investors. ETFs can be passively or actively managed. Index-based ETFs, like index funds, track the activity of a securities index.6
What are the costs associated with passive investment?
Passive investing is often less expensive than active investing because fund managers are not picking stocks or bonds. Passive funds allow a particular index to guide which securities are traded, which means there is not the added expense of research analysts.
Even passively managed funds will charge fees.7 Whenever deciding what kind of fund to invest in, investigate the associated costs.
What kind of returns can you expect from passive investing versus active investing?
Actively investment aims to drive up returns by pursuing frequent trading, but these returns are diminished by the fees associated with professional management and frequent buying and selling. Research shows that few actively managed funds give investors returns above benchmark over long periods of time.8
Passive investing targets strong returns in the long term by minimizing the amount of buying and selling, but it is unlikely to beat the market and result in outsized returns in the short term. Active investment can bring those bigger returns, but it also comes with greater risks than passive investment.
The Bottom Line
Passive investing has pros and cons when contrasted with active investing. This strategy can be come with fewer fees and increased tax efficiency, but it can be limited and result in smaller short-term returns compared to active investing. Passive investment can be an attractive option for hands-off investors who want to see returns with less risk over a longer period of time.