In this post I’m talking about active vs passive investing.

Active vs passive investing is one of the biggest debates going around when it comes to the financial services industry.

Why you say?

Because investment markets equal big business. There are investment houses on both sides of the argument that sell both actively managed and passive investment products.

While the debate is never won so to speak, popularity for both sides waxes and wanes and as a result, so too do the funds of investors. The stronger the case, the more investment dollars that flows into the investment type.

What is the difference between passive and active investment styles?

The primary way to understand the difference between active and passive investing, is to know that an active investor tries to “beat the market return” while a passive investor tries to “achieve the market return”.

Put simply, actively managed funds have managers who pick shares to invest in that they think will return better than the market as a whole, by relying on research and human judgement calls to determine when they should buy and sell the underlying investments of the fund.

Passively managed funds are essentially the opposite of this.

Generally speaking they are things like exchange traded funds or index funds.

Passive investment funds explained

An exchange traded fund [ETF] is traded on the stock market like a share.

It is made up of a basket of assets (like shares, bonds, commodities or a mixture of all) and generally tracks the performance of an index or benchmark – like the S&P/ASX 200 for example.

They do this by either holding in the portfolio the contents of the index itself OR a representative sample of the contents in the index.

Understanding active vs passive in action

To explain the difference – I like to use the analogy of doing the grocery shop.

Imagine walking into the supermarket and being handed a pre-selected shopping basket of groceries. This is like an ETF or passively managed fund.

Your basket may be all dairy, all fruit and vegetables, all meat or a combination of foods – which one would depend on the benchmark or the index that your basket is trying to mimic. Because they mirror a market index there is no need to hand pick individual investments – it’s already been decided.

Whereas with actively managed funds, the grocery basket is constantly re-stocked based on the research and judgement calls of the individual who is pushing the trolley (the fund manager) putting things in and taking things out.

He or she is trying to outperform the chef using the pre-selected shopping basket so to speak.

With passive investing there is limited buying and selling activity – with investors generally seeking long term growth and generally of the point of view that they will ride out any short term market fluctuations.

Active investors however will buy and sell their investments more often seeking to achieve a higher return based on specific research and analysis.

How does this impact you – the beginner?

When you’re deciding how to invest your money you need to be conscious of the following:

  • Risk
  • Return
  • Cost

These factors all differ between active and passive investments and understanding the two styles of management helps you to better choose the individual investments that suit you as an investor.

Investing into a passively managed fund means your returns will match the performance of the index being tracked, for better or worse.

Meaning if the stock market goes up, your portfolio will also go up, but if the stock market falls, your portfolio also falls in value.

Whereas with an actively managed fund however, an investment manager is always seeking to beat the market return.

They may use an index as a benchmark but then handpick shares, adjusting their exposure to certain investments an certain times, which theoretically means they could profit in both a falling and rising market & subsequently deliver a higher return to investors.

However, the reality does not quite ring true.

Standard & Poor’s release the “SPIVA Australia” scorecard twice a year which compares how active funds compare to passive funds in terms of out-performance of the relevant benchmark.

For the period ending 31 December 2015 it shows that the majority of active managers did not outperform their respective benchmarks over a 5 year period.

In Australian equities, over 70% of active managers failed to beat their benchmarks over five years.

What this means, is that despite the research and professional decision making designed to provide a superior market return to investors, in 7 out of 10 cases, investors would have achieved a higher net return had they invested in a passive ETF instead.

These are not stand out results either, this is the general trend.

One of the biggest reasons this is so is due to the higher costs associated with actively managed funds.

Active fund management is big business. Larger funds employ analysts who look at a company’s performance within its sector.

Fund managers may even personally visit company management of the entities they invest in, to hear about plans to improve and sustain growth or, in the case of poor performance, to grill management over its plans to resolve the issues.

All this research and personal involvement costs money, and that expense is passed onto investors in the form of higher investment costs.

And while all fund expenses have been coming down over time, according to the latest research, passively managed funds remain cheaper overall.

Data from research house Morningstar show that among index funds and ETFs, the average expense ratio stands at 0.69 percent. That compares with 1.21 percent for actively managed funds.

To see how this affects returns of actively managed funds compared with passively managed funds let’s use an example.

If the market is up 12% and average costs of actively managed funds are 2%, then the average active investor will make 10% (12% – 2% = 10%).

If the passive investor is paying only 1% in fees, they will earn 11% after costs.  That is 1% better than the active investor average (which is assuming there is no outperformance from the active fund).

The other difficulty with active management is that you have to do a lot of research. If you’re picking shares yourself with an online broker there’s a lot of research to be done. Even if you’re looking to invest into actively managed funds, while you’re not picking the shares yourself, the research is done on the performance of the fund itself, it’s fees, and it’s management team even.

You can do this yourself as a sophisticated investor, or in most cases, by becoming a member of an independent research company like Intelligent Investor or Wise Owl who do all the research and advise you accordingly.

Truth be told there is some research to be done initially when investing into passively managed funds like ETF’s too. There is no such thing as a quick fix.

However, given the passive investor is seeking to achieve the market return over a longer term investment, there is less ongoing research, which is required by the active investor.

The other point to be made, is that there is no requirement to be on one side of the fence or the other. There are plenty of investors who have a foot on both sides of the camp – acknowledging the opportunities to be had with each.

It is worth looking at what your goals are when it comes to risk & investment returns and in the context of your own circumstances so you can start to decide what kind of investor you are at this point in your life.

Rebecca xx