A Closer Look At Active vs. Passive Investing Strategies

A Closer Look At Active vs. Passive Investing Strategies

By Yash

In the past several years, investing in index funds has become one of the main strategies for numerous investors who are happy with replicating the returns the financial markets give instead of defeating them. Research by experts has shown that in many situations, the active investment managers cannot choose enough victors to justify the fees they charge for managing their funds. You may think that the debate of active vs. passive investing strategies is only for the nigh net worth individual and not for the average investor. The funds that are actively managed can still play a major role in creating a diversified portfolio. Financial experts say that even big investors often use passive investments for a lot of their holdings. But according to them, active investing can be good for some parts of the portfolio. This includes the portion of the portfolio that is involved in little-known or illiquid securities. There may also be holding that is targeted towards a certain purpose. This may include reducing the losses attained when the financial markets are going through a bearish stage.


Why Go Active in Active vs. Passive Investing


Active funds are those funds that are operated by some portfolio managers. Many managers are specialists in choosing individual shares that they feel will outperform the rest of the financial markets. There are other fund managers that focus on putting money in industries or sectors that they feel are going to do well. There are also managers that do both of these things. Many portfolio managers are supported by groups of analysts who undertake a lot of research to find out great investment opportunities. The thought behind such actively managed funds is that they permit ordinary investors to get professional stock pickers to manage their cash. When their choices do well, these funds can give performances that defeat the market over time. This is valid even after the fees are paid. But the investors involved in these funds should bear in mind that there is absolutely no guarantee that such a fund will be able to give a performance that beats the index. 

There are many funds that do not. There is research that shows that only a few active funds are able to do better than the financial markets. This is mostly because of the higher fees. It is not sufficient to defeat the index. The manager also has to beat the fund's benchmark index by enough to cover the fund's expenses. This can be a major challenge when it comes to the real world. A few years ago, more than seventy percent of large-cap actively managed funds in the United States did worse than the index. This was according to a measure of the performance of the actively managed funds compared to the relevant S&P index benchmarks. Over the previous four years, nearly eighty percent of the large-cap and active funds in the country did worse than their benchmarks. When everything goes well in the markets, active investing can give good performance over time. But, when that does not happen, the performance of any active fund can lag behind the benchmark index. In either case, an investor will have to shell out more money for an active fund rather than a passive one.


Why do Many Choose Passive in Active vs. Passive Investing


Passive funds are also known as passive index funds. These are created to duplicate an index in the composition of their securities. It is crafted to match the overall performance of the index that they are tracking. It cannot defeat nor lag behind the index. This means that they go up when any index is increasing. But it also means that they decline when the index is bearish. As the name states, these passive funds do not have human managers making decisions regarding selling and buying. These funds have very low fees because they do not have to make payments to fund managers. The fees for both passive and active funds have declined over time. But active funds still cost a lot more. A few years ago, the average expense ratio of such actively managed mutual funds was nearly 0.77%. According to official statistics, this was a decline of 0.27% in two decades. But compared with the expense ratios for funds that are passively managed, the difference is stark. The expenses in that were only about 0.09%. It was a decline of nearly 0.2% in two decades. This difference in the expense ratios of both actively and passively managed funds may not seem like a lot to you. Still, it can add up to a significant amount over time.


Active vs. Passive Investing Strategies to Get Good Returns


There is much to consider when considering the debate between active vs. passive investing. But it is true that the former has tended to give more benefits to investors in some investing scenarios. The other scenarios have seen favorable outcomes with passive strategies. For instance, when the economy is weak, or the financial markets are volatile, the active managers may outperform the markets more often than not. On the contrary, when some shares within the financial markets are moving together, or equity valuations are not fluctuating, the passive strategies may be a better fit. This all hinges on the chances given by various sectors of the financial markets. Investors may get the advantages of both worlds by mixing both active and passive strategies. It will help to leverage these insights. The conditions in the financial markets keep changing with time. So, it takes an informed eye to find out when and how much to go towards an active or a passive fund. If you want to go with both, it is also good to note that getting consistently good returns through active funds has been a lot more difficult within some asset classes and sections of the financial markets. These include the shares of the big firms in the country.

It may make a lot more sense to go towards passive funds in these segments and rely more on active investments in areas of the financial markets where it has proven to be more profitable over time. This includes sections among international shares in the emerging markets or those of the country's smaller firms. There are several investors who have very strong opinions about the debate of active vs. passive investing. They may not agree with our view that both of these avenues can find a place in the portfolios of investors. Your top priority right now as an investor in the financial markets is to reduce your trading costs and fees. Then, such a portfolio that combines both the funds may make good sense for you. When investors care more about things such as liquidity, return, and risk, and less about the fees, they can opt for a mixed approach. It is good for both aggressive and conservative investors. As with the various choices faced by the investors in the financial markets, it finally comes down to personal goals, timelines, and priorities.




When you think about active vs. passive investing strategies, you have to keep a few things in mind. For people who do not have any time to research active funds and do not have any financial advisors, it may be a better option to go with passive funds. You will not lag behind the financial markets. Also, you will not have to shell out huge fees. For the investors willing to be a little involved with their investments, passive funds are a method to get exposure to individual regions or sectors without having to spend a lot of time researching individual stocks or active funds. But it does not have to be a choice between one or the other. Several investors have created diversified portfolios by combining active funds that they have researched with passive funds that invest in segments they do not know a lot about.