Active vs. Passive Investing: An Overview

Whenever there’s a discussion among financial advisers about active or passive investing, it can pretty quickly turn into a heated debate because investors and wealth managers tend to strongly favour one strategy over the other.

At Executive Wealth Services, the central investment proposition leans toward a passive approach to investments, on the basic principle that keeping costs as low as possible is a cornerstone of maximising client outcomes. Passive investing is also in keeping with our clear, fair and transparent approach to investment affairs in that passive fund managers tend to quote returns net of charges whereas most active managers tend to quote their returns gross.

In our experience the difference in annual costs of investing passively as opposed to actively can be as much as 1-2.5% additional cost per annum, in round figures that can be as much as £12,500 on a portfolio value of £500k

Over the lifespan of an investment portfolio which can be as long as two or three generations when the portfolio is subject to intergenerational succession, these costs can be hugely detrimental to the net return achieved by the investor.

It should be remembered that on top of fund management costs, annual platform and advisory costs will also be payable pushing up the costs and the ‘hurdle rate’ of a portfolio even further.

As if the demands on the portfolio after this were not substantial enough, the conscientious investor must always add inflation into his calculation when determining his ‘Real Return’. Thus, in a number of portfolio’s that we at EWS have reviewed and analysed in the recent past we have saved our clients significant sums on their annual charges and provided an environment more conducive to growth.

 

What is Active Investing?

Active investing, you’ll not be surprised to learn, requires someone to act in the role of portfolio manager. The goal being to beat the stock market’s average returns and be able to immediately take advantage of short-term price fluctuations. The role requires a much deeper analysis and the expertise to know when to buy into or out of a particular stock, bond, or other asset. A portfolio manager usually oversees a team of analysts who look at qualitative and quantitative factors, then make educated choices to try to determine where and when that price will change. So, while the active money manager will argue they’ll perform better in a rising market, they also argue that they will lose less in a falling market.

Active investing requires investor confidence that whoever is investing the portfolio will know exactly the right time to buy or sell. Successful active investment management requires being right more often than wrong.

The SPIVA Scorecard is a robust, widely -referenced research piece conducted and published by S&P DJI that compares actively managed funds against their appropriate benchmarks on a semi-annual basis. They offer analysis on actively managed funds performance in the following countries and regions: Australia, Canada, Europe, India, Japan, Latin America, South Africa, and the U.S.

The SPIVA scorecard highlights that, “…actively managed funds have historically tended to underperform their benchmarks over short- and long-term periods. This has tended to hold true (with exceptions) across countries and regions. Another recurring theme is that even when a majority of actively managed funds in a category have outperformed the benchmark over one time period, they have usually failed to outperform over multiple periods.” https://us.spindices.com/spiva/#/about

The SPIVA card scores 78.52% of Large Cap funds in the US underperformed S&P 500 in the US over the five years to June 30th 2019. In Europe, over the same time period, 77.53% of actively managed funds underperformed the S&P Europe 350 index. These statistics have been confirmed and reconfirmed for many years by the most robust academic research.

 

What is Passive Investing?

If you’re a passive investor in low cost index tracking fund you limit the amount of buying and selling within portfolios, making it a very cost-effective way to invest – not least to avoid transaction costs of every buy or sell action. A passive strategy requires a buy-and-hold mentality that resists the temptation to react or anticipate the market’s every move.

The prime example of a passive approach is to buy an index fund that follows one of the major indices like the FTSE 100 or 250. Whenever these indices ‘promote’ or ‘relegate’ their constituents, the index funds that follow them automatically revise their holdings by selling the stock that’s leaving and buying the stock that’s joining the index. This is why a ‘promoted’ stock into one of the major indices is no small matter – it guarantees that the stock will become a core holding in thousands of major funds.

When you own tiny pieces of thousands of stocks, you earn your returns simply by participating in the upward trajectory of corporate profits over time via the overall stock market. Successful passive investors keep their eye on the prize and ignore short-term setbacks or even sharp downturns.

It is possible to blend in huge levels of asset class, geographical and investment sector diversification into the index tracking philosophy to create blended off the shelf investments suitable for the average retail investor.

Hollywood and fiction writers tell big stories filled with buying and selling stocks and bonds and all of the associated excesses – but they distance the average investor from the data that informs. Investing can be a very simple and cost-effective process. The barriers to understanding often result in investors feeling out of their depth and so place their trust in sales orientated advisory solutions which are actually detrimental to the life objectives that they are trying to satisfy.

In summary, you may think a professional investment manager’s skill, vast financial resources and all that technology would trump a basic index fund? Generally, they don’t. If we look at performance and cost, in our opinion passive investing works best for most retail investors. Study after study (over decades) shows disappointing results for active management. Only a small percentage of actively managed funds ever do better than passive index funds.

Accepting that passive investment is the most appropriate avenue for the vast majority of our clients allows us to spend more time honing the critical factors of their investments, i.e. their motivations and objectives. By minimising costs and maximising performance we find that more and more of our clients are able to enjoy the fruits of their decisions; for family, health and wellbeing.

It is as true now as ever it was; investment philosophies should be all about alignment to each client’s specific goals and risk profile. 

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.