Passive Vs Active Investing

As briefly mentioned in our related article The Myth of Passive Investing; we are still calling it a stock market, but these days it has many more indexes than it does stocks. There are nearly 6,000 indexes today, up from fewer than 1,000 a decade ago. Meanwhile, the number of stocks in the Wilshire 5000 Total Market Index has shrivelled to 3,599 from 7,562 in 1998. The Wilshire 5000 is a market capitalisation-weighted index composed of publicly-traded companies.

Understanding passive and active investment differences

Passive investors tend to limit the amount of buying and selling within their portfolios, making this a cost-effective way to invest. The strategy requires a buy-and-hold mentality. That means resisting the temptation to react or anticipate the stock market's next move. Some problems surround this strategy; we touch on this in our advantages and challenges section below.

A chief example of a passive investment approach is to buy an index fund or Exchange Traded Fund (ETF) that follows one of the major indexes like the S&P 500 or Dow Jones. Whenever these indexes switch up their securities, the index funds that follow them automatically switch up their holdings by selling the stock that is leaving and buying the stock that is becoming part of the index. Therefore, when a company becomes big enough to be included in a major index, it guarantees that the stock will become a core holding in thousands of significant funds.

When owning small pieces of multiple stocks, returns can be earned by simply participating in the upward trajectory of corporate profits over time via the collective stock market. Passive investors tend to ignore short-term setbacks or even sharp downturns.

Active investors take a hands-on approach which requires an experienced portfolio manager. The portfolio managers goal with active investing is to beat an index, or the stock market - taking advantage of short-term price fluctuations. This method requires detailed analysis and expertise to know when to sell and when to buy stocks, bonds or assets. Portfolio managers often oversee a team of analysts who research qualitative and quantitative factors, then deploy informed decisions within their active portfolio. Active investors, at times, take advantage of passive strategies, selling or moving funds out of an index at the right times to gain the largest profit.

Active investing requires experience and consistent combing of the market's activity, this includes aspects beyond data numbers and buying-selling trends. A genuinely savvy manager will consider a company's management and contemplate their business history. Detailed research such as this requires confidence in their abilities and dedication to the long hours required in beating the market.

Active portfolio managers can include passive strategies into their managed portfolio - as mentioned earlier, thus diversifying in uncorrelated areas for added protection. When a passive index drops, your entire portfolio will suffer without diversification - active managers avoid this by moving funds and anticipating a market decline.

““Passive investing is done in vehicles that make no judgements about the soundness of companies and the fairness of prices.” ”

– Howard Marks, Oaktree Capital

Advantages and challenges in passive and active investing

Throughout the first five months of 2017, investors steered $338 billion into passive mutual funds and ETF's - that is on top of last years record inflows of $506 billion, according to Morningstar Investment Research. If this continues, passive funds could take in more than $800 billion in 2017, a 60% jump from 2016's record and nearly double the haul from 2015. With these astonishingly inflated stats in mind, it becomes increasingly important to discuss whether investors are better off with passive index methods or active diversification in indexes and well-researched stock-picking.

Passive Investing

Advantages:

• Bull market - Passive follows an index, so in a bull market when the index is heading upward, passive strategies are considered to be effective. 
• Low fees - There is nobody picking stocks, so oversight is less expensive. Passive funds simply follow the index they use as a benchmark.
• Tax efficiency - The buy-and-hold strategy does not typically result in a massive capital gains tax for the year.

Challenges:

• Bear market - Passive investors tend to become "active panic sellers" in a bear market, letting emotion take hold and pulling out of the index at a loss. Challenges in a Sideways market are similar to those of a Bear.
• Too limited - Passive funds are limited to a specific index or predetermined set of investments with little to no variance; thus, investors are locked into those holdings, no matter what happens in the market.
• Capped returns - By definition, passive funds will pretty much never beat the market, even during times of turmoil, as their core holdings are locked in to track the market. Sometimes, a passive fund may beat the market by a little, but it will never post the big returns active managers crave unless the market itself booms. Active managers, on the other hand, can bring more significant rewards (see Active Investing below).
• Zero accountability - When following an index, you are buying multiple stocks from multiple companies, meaning you may have holdings in well-run companies, and companies with earning less than zero.
• Diworsification - AKA: the lack of proper diversification - The process of adding investments to a portfolio in a way that the risk/return trade-off is worsened. Diworsification is investing in too many assets with similar correlations that will result in an averaging effect. The index a passive fund follows tend to have the same stock appearing in multiple indexes - so when these companies suffer, your whole portfolio will as well - hence the averaging effect.
• Forced buys - When money pours in, passive funds must purchase stocks in the same proportion as the indexes they track - with no regard for stock price or fundamental information. This is not only dangerous for the market, but for the economy as a whole.
• Cap-weighted indexes - Index buyers have no discretion but to load up on stocks that are already overweight (and often pricey) and neglect those already underweight.

““If you buy an index fund for the Russell 2000 (small-cap stocks), not only are you getting stocks of well-run companies, you are also buying the 30% of the small-caps that have less than zero earnings.””

– John Mauldin, Mauldin Economics

Active Investing

Advantages:

• Flexibility - Active managers are not required to follow a specific index. They can buy stock in developing companies they have found through research with a team.
• Hedging - Active managers can also hedge their bets using various techniques such as covered-call-options or put-options, and they are able to exit specific stocks or sectors when the risks become too big. Passive managers retain the stocks their index track holds, regardless of how they are doing.
• Tax management - Even though this strategy could trigger a capital gains tax, advisors can tailor tax management strategies to individual investors, such as by selling investments that are losing money to offset the taxes on the big winners.
• Diversification - An essential part of your investment portfolio. Active managers can trade in and out of not only individual stocks but indexes as well - making them a well-rounded choice.

Challenges:

• Higher fees -Thomson Reuters Lipper pegs the average expense ratio at around 1.5-to-2% for an actively managed equity fund, compared to 0.6% for the average passive equity fund. Fees are a little higher to support an analyst team researching equity picks. Although, it should be noted that it is this team that can end up saving a portfolio from sharp downturns by spotting them in advance.

Making the strategic choice

Many investment advisors believe the best strategy is a blend of active and passive styles. We agree; however, it also depends on you, the investor. A retired investor or a working investor will have different goals; it also depends on wealth. Variation in investor types does tip the scale toward active managers, as active managers can assess your situation - whether you are retired and requiring income from your investment, or working and looking to increase your portfolio's returns with a willingness to take on more risk.

“"The passive versus active management doesn’t have to be an either/or choice for investors. Active managers combining the two can further diversify a portfolio and actually help manage overall risk."”

– Dan Johnson, Fee-Only Network

We can reflect on a real-world example as well, considering passive versus active models' ability to bounce-back after a dip in the market; Vanguard Total Stock Market Index (VTSMX) took 43 months to recover its losses after the 2000 bear market - a passive strategy. In comparison, InvesTech's active model portfolio took only 11 months to recover.

Bottom Line

Diversification is key and Diworsification is dangerous.

Passive investment Diworsification can be disguised as Diversification by holding multiple ETF's or by following numerous indexes, passive strategies appear to be diverse. Investors often achieve this by investing in a number of passive strategies that have similar investment approaches within the same grouping of shares. Having too many assets with similar correlation will result in an averaging effect - effectively removing any edge you could have had on the market.

An active manager can balance both indexes and stock-picking, allowing them to enter and exit indexes at the right time, while additionally permitting the purchase of underweighted stocks and sale of overweight when necessary. Equity Strategist at Bank of America Merrill Lynch, Savita Subramanian found that buying the ten stocks most underweight by active funds, while selling the ten that are most overweight by the active fund, earned annualised returns near 19% since 2008 - something that cannot be done following an index with a passive approach.

It is not the demise of active managers. Instead, it is the demise of the lousy active manager.