Investing and Trading

Active vs. Passive Investing – The Difference and Potential Effects in Various Market Environments

Author: Aleksandar Adamovic October 12, 2018

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Passive Investing has over the last couple of years gained huge market share in the investing and asset management world. Investors have flocked to passively managed funds that not only are cheaper than active managers, but also outperform them. Some market observers have noted this 10 year of outperformance has been due to benign monetary conditions. Central Banks around the world have since the financial crises kept rates close to zero with the implicit back-stop, leading markets across the board grinding up. As a result, passive investing has been the preferred form of investing. Who needs pay more money for a human being that tries to beat the market, when you can pay much lower fees just to hold indexes which all go up. With the onset of interest rate hikes, these market condition could change.

Recently, there has been a debate within the investor community about the merits of either active or passive investing in various markets. Over the last couple of years there has been a massive inflow into passive funds, while at the same time the corresponding outflows from active funds. We take a closer look at both to get a better understanding of the pros and cons.

Active Investing

Active investing is basically what most people call “investing”. Buying and selling individual stocks (or other assets such as bonds) based on the fundamentals of the assets. The investment made by an individual, mutual fund, hedge fund or any other fund is based on each single investments underlying fundamental drivers. In another words, buying or selling a stock based on if the business or market is good. As an active investor one makes an investment decision on case by case basis. Active managers try to identify market inefficiencies to generate returns. Often, the goal of an active investor, say mutual funds is to beat their benchmark. An active investor’s benchmark can be beating the S&P 500 Index.

Passive Investing

As a passive investor, the goal is not about beating any specific index, but more mirror the returns of whatever index one specifies. In other words, a passive investor will try to own all the stocks in the index, in proportion of which they all are represented in an index. Passive investing has its roots in the belief of efficient market hypothesis. Its essence is that stock prices generally reflect all available information at any given time. Subsequently, it will be very difficult to “beat” the market over a long period of time. Hence, one might as well try to just buy the “indexes” one aims to follow.

Costs differentials

An Active fund, has most likely various investment professionals that evaluate and make the investments decisions on the basis of being able to outperform their benchmark index. As there are actual individuals making these decisions, the cost basis of an active fund tends to be higher than a passive fund, let be a mutual fund, hedge fund or any other fund. Using mutual funds as an example your typical active fund charges around 1.0-1.5% of assets under management every year.  Passive funds often only use algorithms of various forms to construct/adjust their portfolios according the index they mirror. This means substantially lower costs as there is no need for hands-on human assessment of the investments. The average passive mutual fund charges around 0.25-0.35% of assets under management every year.

From a cost differential there are clear advantages of choosing a passive fund as they are substantially cheaper than an actively managed fund.

Returns

In 2016 study by S&P Dow Jones showed that 90% of active equity mangers did not beat their benchmark indexes over a 1, 5 and 10 year period.  Major part of this underperformance was due to expenses. A Wharton business school study showed that on an after tax-basis, large-cap managed active funds, underperformed their passive peers 97% of the time. Furthermore, in those few cases that an active manager outperformed its benchmark one year, there was only a 10% chance that he/she would be able to continue outperform for 2 more years.

Market Conditions

Since the 2008 financial crises there has been Cinderella like conditions for passive managed funds. Rates have basically been around 0%. Stocks have within and across industries moved in lock-step with each other. In another words, the movement of stocks in various industries has been close to similar regardless of whether it is a “good”, “bad”, “cheap” or “expensive” company. Furthermore, in conjugation, the start of these lock-step movements, more and more investors have funneled money into passive funds, further exacerbating the lock-step movements, leading to even more inflows into passive funds.

All of this might change with the change of global monetary policy. US federal reserve has started raising rates for first time over a decade, aiming to soon lead economy and rates to what would be considered normal levels of 3-5%. This in effect could result in that, the investor notion of fed “back-stop”, buy-every-dip mentality, and generally being long the entire market might not hold any longer.

As a result, the reverse effect of what has driven the outperformance of passive funds over the last decade might come to fruition. Investors will start paying more attention to what is a good/bad company instead of general exposure to the market.

In addition, over the last decade with massive inflows to passive funds, often various sectors have all rallied due these passive funds have been “forced” to buy all constitutes of the indexes they follow. Pushing up the prices of everything. As there is a change in the monetary policy, investors might be rushing to exit a lot of passive funds, with withdrawals from investors forcing the funds to rapidly sell down their holdings, further pushing prices lower.

In these market conditions, an actively managed fund, which managers have the flexibility to buy/hold/sell as they assess is an advantage (“no need to throw out the baby with the bathwater”). Active managers will also have the advantage of risk management as they can enter/exit/re-position themselves when risk and movements become too large/change. Also, a great deal of active managers can hedge themselves in various forms, something simple passive funds cannot do.

Finally, as the last couple days of market gyration and high volatility have shown, when things become more unstable, and not just a straight line up, having access and exposure to active managers could be beneficial.  They can navigate the markets based on judgment instead of mathematically buying/selling based on simple index exposure, hence generate better returns.

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