Passive vs Active Investment

Apr 29, 2021 06:56 PM ET
Passive vs Active Investment

The concept of passive investment is based on the drive to perform the same way as the index you are tethered to. This, therefore, means that a passively invested fund will remain profitable for as long as its performance is at par with the index.

Notably, passive investments are automated, with minimal human intervention.  On the other hand, active investments are managed with an aim of performing better than the market. Active investments are overseen by human investment managers and their teams. 

As highlighted above, these types of investments are overseen by human managers. The people managing them are highly competent market analysts who lead teams of traders, researchers, and other key personnel. They have to dig deep to understand market dynamics and know the underlying forces responsible for changes in fundamentals.

Fund managers have to put into consideration factors such as earnings reports, the economic calendar, acquisitions, geopolitical influences, among other factors. In addition, they have to get their technical analysis right and know the correct combinations to use before making critical trading calls. In the end, they always aim to beat the benchmark.

With all that effort and time invested, it, therefore, means that investors have to pay a hefty fee to their portfolio managers. Further to that, actively managed funds are constantly up against automated algorithms running passive investments. Consequently, active investments often fall short of expectations and lose against market indices.

Advantages of passive investing:

They cost lesser fees: Because they are automated and not managed by human portfolio managers, their fees are comparatively low compared to actively managed investment funds.

They are transparent: Unlike active portfolios, passive investments are an open book, and investors know exactly which bonds and/or stock and other assets are within the index.

They give tax breathers: The frequency of trade of passive investments is such that they take some time before investors are ready to sell their assets. They are mostly hold-and-see assets, and therefore investors do not have to file capital gains taxes as frequently as is the case with active investment funds.

Disadvantages of passive investing

They are restrictive: With passively invested funds, your money will be restricted to the index or assets it is tethered to. This means that you do not get to try your hand on potentially high-return investment opportunities that may emerge along the way elsewhere.

Limited profit: Since they are tied to indices, the chances of passive funds performing better than the market are usually slim. They can, however, return impressive profits when the market spikes, but their profitability cannot match that of active funds when fund managers get their trade right.

Advantages of active investing

Unhindered investment options: Managers of active funds have a free hand to select the stocks/assets they think can return a profit. Passive investments, on the other hand, are restricted to particular indices.

Safe nets: By using techniques such as shorting, active funds can be invested with minimal risk since managers can always dump non-performing or risky assets in their portfolio.  

Offer strategic tax payment options: Investors can always assess their portfolio and devise suitable mechanisms to meet their capital gains tax obligations. For example, they can short poorly performing stock and use their returns to pay for the taxes of better-performing assets.

Disadvantages of active investing

High fee charges: With active funds, investors have to cater for operational costs, which are often high. For one, frequent trading equals frequent transaction costs. Secondly, you also have to pay the investment managers and their team. Ultimately, this can eat a significant part of your profit and possibly create net losses.

Relatively riskier: You cannot hold it against the fund managers when they make the wrong calls and lose your money. The potential profit margins are high, but beating the market is never an easy task, even for experienced managers.

Are you choosing between passive and active investment?

From the discussion above, it is apparent that it is comparatively easier to be a passive investor than an active one. Passive investments are hands-off investments relative to active funds.

Automation of trade and availability of cheaper mutual traded funds as well as ETFs make passive investments attractive. In addition, these types of investments give room to do other things instead of spending a lot of time being worried about capital gains tax. It is therefore understandable why many people may opt for passive investment.

For active investing, you need to understand your trade and know the market well if you are to return a profit. Getting your technical and fundamental market reading right is the first step to winning in such an environment. 

However, even then, it might still be quite difficult to make the right calls consistently. At any given time, you will be juggling many balls, and there's always a chance that you'll drop some at one point. In addition, you will also have to deal with frequent tax payments and cater to other operational costs.

These factors make active trading a riskier venture. Therefore, active fund managers are often in the line of fire because of the high odds they must overcome to perform better than the benchmark. However, there's a reason why some fund managers are more sought-after than others.  

The truth of the matter is that some managers have a better understanding of the markets and therefore have a higher win rate. You may therefore want to consider this factor before you outright dismiss active investment.

Bottom line

These two investments are significantly different, but both of them have strengths and limitations, as discussed above. You should, therefore, not restrict yourself but consider these factors before settling on the best option. In the end, you always have an option to blend both.

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