To some of us, the world of investing, through its various terms and strategies, feels complex and overwhelming. As a result, this may cause feelings of uneasiness when navigating the wealth management space. If you identify with these statements, take a moment to remind yourself that finance is not unique in this way. Whether it’s technology or gardening it takes time to gain knowledge and familiarity with a topic. An important and frequently discussed topic that has captured the attention of millions of investors, from beginners to advanced, is that of passive versus active investing. While the two strategies use different techniques, each strategy’s objective is to yield positive inflation-adjusted returns to the investor. As an investor, understanding these two strategies can unlock the doors to well-informed choices that meet your criteria and preferences.
What is Passive Investing?
A passive investing strategy aims to duplicate the returns of the overall market by following a specific index, such as the S&P 500. Generally, the strategy is attained through the creation of an Exchange Traded Fund (ETF). An ETF will hold the same stocks as the index it tracks and in the same proportion as the index. At the heart of passive investing is Efficient Market Hypothesis which hypothesizes that markets are efficient and therefore extremely difficult to beat. Advocates of passive investing focus on the capital market’s ability to generate positive returns over the long run. As a result, passive investing attempts to create wealth gradually, by holding securities over an extended period of time. The strategy, through the use of Exchange Traded Funds, has gained tremendous popularity over the last 10 years. Two primary reasons for ETFs recent gain in popularity are: 1) the construction of such products does not require as large of a skillset as active investing, consequently ETFs are offered at a much lower cost to the investor and 2) from 2009-2017, the North American markets have had tremendous results, with S&P 500 for example, returning ~15% on annualized basis.
What is Active Investing?
The main objective of active investing is to generate higher returns than the market/benchmark which it follows. This excess return is known as alpha. Simply stated, active investing is achieved through stock picking. An individual or investment manager believes that they can identify stocks which will outperform the broad market, and therefore invest only in those securities, while not investing in stocks which they believe will underperform. For example, an active investment manager may select only 30 stocks, of the 500 stocks in the S&P 500 index. These will be stocks that their research has identified to be the 30 stocks which will produce a better return than investing in all of the 500 stocks. As a result, the portfolio no longer has the same stocks and their respective weights as the index. The process of active investing requires great skill, such as performing macroeconomic and industry research, analyzing the financial statements of a company and forecasting its financial health.
The Benefits and Drawbacks of Passive Investing
- Lower cost: Given the lack of complexity in product structure, ETFs are offered at a much lower cost.
- Tax minimization: Considering that investments are held for an extended period of time, passive investing minimizes investment related tax implications associated with buying and selling securities.
- Lack of downside protection: While by mimicking market returns, passive investing can generate marvellous results in an upward market, on the hand, the strategy does not provide protection to investors when markets take a turn for the worse.
The Benefits and Drawbacks of Active Investing
- Flexibility to deploy a wide range of strategies: Active investing provides the investor/portfolio manager with flexibility to deploy a wide range of strategies in order to beat the market/benchmark which it follows. Aside from overweighting undervalued stocks and underweighting overvalued stocks, the portfolio manager can also engage in various complex strategies such as short selling, leverage and derivative strategies, to name a few.
- Potential to outperform the market: Through active selection of stocks which are expected to beat the market, active investing provides an opportunity for an investors portfolio to outperform the index. Furthermore, active management allows investors to be exposed to various investment vehicles that are not currently available via passive investing.
- Ability to engage in downside protection: Through various strategies, the portfolio manager is able to engage in downside protection when markets take a turn for the worse.
- Higher cost: As a result of the effort required in the strategies employed, active investing products are generally offered at higher fees than passive products.
- Potential to underperform the market: Active investing strategies have the potential to underperform the market during positive or negative market swings.
Conclusion: Active Investing vs. Passive Investing
So, which strategy is a better option? That depends. In fact, the two strategies can also efficiently coexist in one’s portfolio. Through a passive strategy one would be able to reap the benefits of an upward market while through an active investing vehicle, one would be able to enjoy downside protection and partake in the opportunity to outperform the market. At Wealth Management Canada, we believe that a great active investment manager can and will outperform the market over the long-term. However, in situations where an investor is unable to work with the best active firms, passive investing is the next best option, rather than working with an active manager who can’t deliver alpha.