Active vs. passive investing

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Active and passive investing are two of the most debated approaches to building a portfolio. The two nearly opposite strategies are compelling in their own ways: active investing appeals to the desire to make lots of money quickly, while passive investing promises slow and reliable earnings over a longer period. But what other differences are there between the two, and does one offer a higher guarantee of success than the other?

What is active investing?

Fund managers run active funds, independently assessing each investment to try to beat the market. As an investor, you'll typically choose an active fund based on its mandate, while the fund manager follows a specific strategy to take advantage of the market's peaks and troughs. Managing an active portfolio takes time — fund managers often track price movements multiple times a day, buying and selling accordingly. This level of attention comes at a cost: active funds generally charge higher fees, and there's no guarantee the strategy will pay off. If it does outperform the index, though, your returns will be ahead of the market.

What is the goal of active investing?

When comparing active vs. passive investing, the ultimate goal is the same: to make money. However, the mechanisms by which they achieve this are completely different. While the goal of passive investing is a slow and steady profit, active investing seeks to make short-term profits quickly. This happens as your fund manager closely tracks the activity of your investments and takes full advantage of short-term price fluctuations.

What are the benefits of active investing?

Active investing offers several potential advantages over a passive approach, from the chance of higher returns to closer, more responsive portfolio management.

• Greater rewards. Active funds have the potential to outperform all of their peers or their benchmarks. And greater risk-adjusted returns are possible with a quality active investment strategy.

• More short-term opportunities. Portfolio managers can take advantage of momentum in the market, or use swing trading strategies, making headway on their portfolio in very short periods of time, especially compared with passive investing where you don’t buy and sell stocks and try to "ride out" dips in the market.

• Far greater flexibility. A portfolio that is managed with a strategy of active investment can see stocks turned around quickly; purchased when they’re undervalued and divested as their value drops. This offers a greater level of risk management, as money managers can adjust their client’s portfolios to align with prevailing market conditions.

• Working with an expert. With an experienced portfolio manager overseeing your investment, their knowledge will allow them to hedge their bets, using different techniques to offload stocks once they pose a risk to your portfolio.

What are the disadvantages of active investing?

While there are many benefits to active investing, it can come with its downsides, including a greater risk of losing money than with passive investing.

• Key man risk. When active investing, you have chosen a particular fund manager and are trusting in their instincts, research and decision-making. This brings with it the risk that your fund manager leaves, changes their strategy, or simply has a poor strategy, which can lead to you losing money on your investment.

• Potential for underperformance. If your fund manager makes poor choices, your portfolio may perform worse than the market. This isn’t uncommon.

• Higher fees. Active investing comes with higher fees as you are paying for a fund manager to invest your money. With a high turnover of stocks, too, can come higher commissions and taxes that can eat into your portfolio’s returns.

• Barriers to entry. Active funds can often set minimum investment amounts which can limit who is able to invest.

What is passive investing?

Passive investing tracks a chosen index, typically managed by an algorithm rather than a fund manager. Passive funds, also called tracker funds, generally charge lower fees than active funds. Passive investing means choosing an index to follow — for example, the S&P 500, oil, gold, or a specific sector — and holding that investment through its ups and downs for long-term returns.

Passive investing limits the amount of buying and selling within your portfolio. If you invest in a major index like the S&P 500, your portfolio simply mirrors any change to the index's constituents, automatically adding whichever new companies join it.

What is the goal of passive investing?

Like active investing, the goal of passive investing is to make money, however this is achieved over a far longer period, and ideally with a higher rate of success than active investing. Passive investing aims to avoid the larger fees of acting investing, with the goal of building wealth gradually.

What are the benefits of passive investing?

Passive investing offers several potential advantages over an active approach, from lower fees to a simpler, more hands-off way to track long-term market performance.

• Underperformance isn’t a consideration. When passive investing, your portfolio will closely track the market, shadowing the index you’ve invested in.

• Fewer fees. Fees for passive investing are fewer than those associated with an active fund. And without the added commissions and taxes which come with constant trades, passive investing is a more cost-effective way to invest.

• Simplicity. Passive funds are far more simplistic than active funds, they require far fewer changes to keep track of, and don’t require a fund manager to oversee your portfolio.

• Long-term returns. Passive investments are more stable as they don’t aim to beat the market. While this can sometimes pay off in dividends, it can also result in a loss. A passive portfolio allows for a slow and steady improvement in value over time.

What are the disadvantages of passive investing?

When passive investing, your investment will closely track the index it follows as its purpose is to follow that index precisely. With the inclusion of fees, your fund will also remain slightly below the curve.

• Passive investment requires patience. This can involve ignoring significant downturns in the market and holding onto your investments, knowing that there will be a payoff in the long-run.

• Returns are smaller. With less risk comes less reward, and as passive funds track the market without buying and selling as things rise and fall, their returns will be smaller and gained over a more extended period of time than active funds.

• There are more limitations than active funds. When passive investing, you are limited to specific indices or sets of investments that you are locked into, regardless of what’s happening in the market.

Summary

While looking at active vs. passive investing can almost seem like a head versus heart decision, this doesn’t need to be the case. Passive investing may appear to have greater success in the long run, however, this requires playing a long game and none of the windfalls associated with active investing. The two are not mutually exclusive and can both play a role in a robust suite of investments; hedging against market downswings with passive investments while also exploring new market trends with active investments.

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