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The pros and cons of active and passive investing
Are you going to choose an active or passive investment strategy? It is an important choice as there can be a big difference in fees. Here we look at the advantages and disadvantages of both.
Despite all the complicated algorithms and confusing terminology, there are really only two investment strategies: active and passive. To invest ‘actively’ is to entrust your money to a fund manager who will try to use their expertise and insight to choose a series of stocks, shares and investment opportunities that they hope will beat the market and make you rich by delivering big returns. To invest ‘passively’ is to ignore managers and simply follow the market’s movements and investing in vehicles such as Exchange Traded Funds (ETFs) or choosing a basket of stocks and shares which mirror overall stock market performance.
Both styles of investing are popular, but they each have their own specific advantages and issues. We’ve put together a few of the most commonly cited pros and cons of both active and passive investing, so you can decide which one may be right for you.
Actively managed funds
Active investing is an investment strategy that involves actively buying and selling assets with the intention of making profits that outperform a benchmark or index. A hedge fund manager is an example of an active investor.
Weighing up the pros and cons of active investing
| Pros | Cons | ||
|---|---|---|---|
| Potentially market-beating returns | Active managers believe that they can beat the market by predicting trends and investing in hand-picked stocks. When they are right, their insight translates into huge returns, which would not be possible if you were following a passive strategy. | Human error | When you are placing your trust in an investment manager, you have to accept the possibility that he or she can make a mistake. They could misjudge market movements, or choose a bad stock and potentially wipe a lot of value off your portfolio in the process. This is why it is vital that you have complete confidence in your active manager, and that you are prepared to stick with them through good and bad times. |
| Flexibility | Active managers tend to have carte blanche over their investment strategy, whereas passive managers may be tied to a particular index or sector. If an active manager decides to switch from tech stocks to healthcare, for instance, they can do it in an instant. | Cost | Active funds have notoriously high fees, with most managers sending you an annual bill, even if their strategy has lost money. On top of this, active managers will also take a cut of any profits, so while you may think you’ve made a 10% profit, after fees and commission it may be 6%. This will have a compound effect on your portfolio value over time. |
| Tax breaks | Believe it or not, some high net worth investors are actually happy to lose money, as they can stack these losses against their taxable income to cut down on their tax bills. This is usually worked into the investment strategies of the very wealthy. | Minimum thresholds | The top managers can afford to be selective about who they take on, and many choose to set hefty minimum thresholds for prospective investors. It’s not uncommon for active managers to seek £250,000 or £500,000 as an initial investment from new clients. |
Passively managed funds
Passive investing is an investment strategy whereby investment portfolios try and generate returns that mirror the returns of the underlying constituents of the portfolios. For example, passive portfolios may be built using exchange traded funds (ETFs) which track the performance of a stock index or other underlying security.
Weighing up the pros and cons of passive investing
| Pros | Cons | ||
|---|---|---|---|
| Cost | Passive investing is probably the cheapest way to access the market, with minimal fees and none of the hefty commission charges that come with hiring an active manager. That means that any money you make is all yours, except a nominal admin fee (typically less than 0.1%). | Stock concentration | Some passive investment strategies are overly focused on large caps, which means that your money may be concentrated to the top 100 or top 50 companies in the country. This robs you of the opportunities to be found elsewhere in the stock market, and can leave your money vulnerable to major political and regulatory events. |
| Long-term results | If you are prepared to invest your money over a long period of time, the stock markets have historically delivered great results. For instance, between March 2007 and March 2017, the FTSE 100 has returned 15.46% despite several prolonged periods of volatility. | Volatility | When your money is invested in the markets, it can be tempting to keep a watchful eye on any stock market movements, and to panic when values drop. Passive investing is best suited to longer-term investors who are happy to leave their money in place for at least a few years – the worst thing you can do is to take your money out when the markets are down. |
| Simplicity | With a passive investment, you always know where your money is and what it’s doing, and you can remove and reinvest it with relative ease. | Limited returns | Passive investments will never beat the market – because they are the market. |
Active vs passive investing — which strategy should you choose?
Despite all the hype, study after study has shown that active investments – on average – do not outperform passive investments in the medium and long term. However, active investors will always insist that their manager is different, and prefer the occasional windfall to a consistent stream of smaller returns. And remember the difference in fees between active and passive investing. You need better returns to outweigh the higher fees that come with active investing.
In the end, it all comes down to risk, reward and what you want to get out of your investing experience.
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