It’s a debate that has been raging for decades. When it comes to investing, is it best to take an active or passive approach? And what is likely to bring about the best returns? These are questions that every investor, wealth manager or portfolio manager will have grappled with at some point – and probably have formed their own strong opinions about. Traditionally, actively managed funds have been the first choice for investors, but in recent years, we’ve definitely noticed that the tables are turning.
Active v Passive
To try and get some clarity over this issue, we should probably start by looking at the two different approaches – and get a fix on what the pros and cons are for each one:
This strategy aims to outperform the market index by stock picking. Actual human portfolio managers and analysts try to beat the stock market by searching out investments that are undervalued, while selling investments that become overvalued.
To be successful, it’s purely a matter of being right more than you’re wrong when buying a particular asset. And while it’s true that active investments can provide greater returns, the risks, fees and expenses also tend to be higher, which that inevitably has an impact on overall performance and returns.
- Flexibility – with an active investment strategy, the investor or portfolio manager can search out different assets, buying and selling them easily.
- Target high returns – fund managers can quickly move in and out of assets in an attempt to beat the markets and deliver big returns.
- Tax efficiencies – although investing may lead to Capital Gains Tax, active managers can tailor tax-management strategies to suit the needs of individual investors.
- Can be expensive – all of this buying and selling will result in higher fees, and that will affect your final investment returns.
- Higher risk – because active investment managers buy and sell based on their own research analysis and timing, they won’t always get it right. And that can lead to greater losses.
- Less diversification – if the main focus is on picking the next winning stocks, portfolios may be highly concentrated with fewer securities.
This is a strategy that’s designed to match, not beat the performance of a specific index or benchmark. Unlike active management, it doesn’t rely on a human to decide when to buy and sell. And with less trading, that means fees and expenses are typically much lower.
A passive investment approach is much more about long-term goals than reacting to short-term gains or sharp market downturns. Passive investors are prepared to buy and then hold on to their investments, letting the market do its thing over the years. And a more diversified portfolio means lower risk too.
- Less risk – with this hands-off approach, less buying and selling and greater portfolio diversification, investing is generally a less risky business.
- Lower fees – since there is little buying and selling, a portfolio is much easier to manage and costs are minimised.
- Tax-efficient – Because there is less trading in the portfolio, that results in fewer investment-related tax consequences.
- Less choice – passive investors usually follow specific indices and investors are likely to be locked into their holdings, no matter what happens in the market.
- Returns relative to the market – passive investing doesn’t target excess returns and will rarely beat the market. Instead, it aims to match the performance of an index or asset class.
What’s the answer?
It’s all a question of how possible it is to predict how a particular fund will perform and if past performance is any indication of what will happen in the future. And that was the focus of recent research carried out by Dimensional, a company that has been in business since 1981 and applies academic research to practical investing.
In their latest analysis of US-based mutual funds, they found that after costs, only a small percentage of funds outperformed industry benchmarks. And that among top-ranked funds based on past results, only a small percentage have repeated their past success. Dimensional hold firm the belief that it’s possible ‘to outperform the market, without having to outguess it’.
You can hear more about their findings in this short video.
The bottom line is, there are no clear-cut answers. You could take an active approach and get lucky. Or you could go for a passive approach and play it safe. However, it seems that in the long run, passive investments are likely to outperform active investments due to the lower costs, fewer timing errors and less likelihood of poor investment choices. And that’s an approach we’ve always felt much happier adopting.
If you’d like to know more about our approach to investing, please feel free to give us a call on 01372 365950.