Understanding active vs passive investing

By Jessica Sier 2 December 2018 4 min read

Welcome to what may be considered one of the most fiercely debated topics in modern finance, the dichotomy between active and passive investing.

Active investing refers to when you deliberately choose individual shares (or other assets) and try to outperform the market.

Passive investing refers to when you buy shares or other assets to track the performance of an index or asset.

Let’s break that down.

Active investing

You are actively investing when you are buying and selling shares based on your own value judgement. Active investors generally continuously monitor their portfolios and change things to make money from and hopefully benefit from profitable conditions.

Active investors use company and market analysis to decide which shares they want to own and then they monitor the conditions of the industry and wider economy, so that if conditions change, they can sell or rearrange their holdings.

An active investor is usually trying to outdo everyone else in the market.

This approach generally involves a higher level of risk, because shares are often more volatile in the short term, but this can sometimes lead to higher returns.

Because active investing generally takes expertise to make it work, people can pay other people to actively manage their money for them.

These are called fund managers.

Fees are one of the most important things to consider when thinking about active investing.

Generally, fees for actively managed funds are higher than those with a passive strategy or ETFs.

Sometimes, they will even have performance fees.

So even if your fund manager does a spectacular job and finds shares that outperform the market, you will receive the return after their fees are deducted.

The thing is, you’re still charged an administration fee if the fund manager does not deliver growth in your wealth.

Even though they’re professional fund managers, there’s risk involved.

You’re placing your trust in them and have to accept they might not outperform the market or may misjudge which shares will perform well. (And they’ll still charge you the fee even if your portfolio falls).

Important: ETFs still charge fees, but because there is less administration involved, they are generally much cheaper than active management fees.

Passive investing

Passive investing usually involves buying a share (or another financial product) that doesn't involve frequent monitoring, buying or selling.

The goal here is to build wealth gradually and this is why they are usually longer-term investments.

Because there are so many people and robots buying and selling in the markets, passive managers generally try and match the performance of the whole market or a sector.

They aren’t trying to beat anybody, they just want to make sure they are performing in line with the general market.

Sometimes they bundle together a well-diversified portfolio of shares that would individually require extensive research, and then track that performance.

In the 1970s, index funds were introduced which are funds designed solely to move in line with an index. An index is a measurement of a section of the share market.

You can choose to track a sector index (like a tech index) or the entire market (like the ASX).

In the 1990s, exchange-traded-funds (ETFs) were introduced. These are sections of the market bundled together but they trade on the exchange like other shares.

Because they avoid constantly buying and selling shares and the need for an investment manager to actively manage the portfolio, passive investment strategies have much lower fees and operating expenses than an actively managed fund.

One of the risks of passive investing is that it relies on the stability of the market. When there’s an overall share market fall, index funds follow.

Active managers use their expertise to try to outmanoeuvre share market falls by rotating and changing their portfolio.

There are also sometimes limits as to how passive index fund managers can manage the funds.

Usually they are barred from reducing a holding even if they think the market is going to go down, because their job is to track the market, not outperform it.

Why is the dichotomy of active and passive investment such a divisive topic?

Well!

Passive investing - in the form of ETFs that trade on the market as securities and other things - is becoming more popular.

Rather than try and select which stocks are going to outperform the market, people generally seem happy to put their money in a passive product that tracks an index.

The problem with this can be that the “buy and hold” nature of passive investments means people aren’t applying estimates on whether something is overvalued or undervalued.

Passive managers usually buy in big sweeps, regardless of what kind of companies they are buying.

This may mean that there is limited understanding of how the company is operating or performing. For example, the companies may not be selling as much as they used to, or the CEO is allocating capital badly or any number of things that aren’t reflected in the market price.

Passive buyers will buy stock and not frequently monitor it, which means they hold the stock even if it is not performing the way it was projected to. However, the fact that there is still investment in the company may keep it operating.

Active managers argue that they play an important role in discerning the good from the bad businesses. In an “efficient market” this is called “price discovery”.

The case against mass passive investment is that ultimately so much money will buy up so many stocks automatically, without regard for how well the business performs in the market. This could potentially result in a market filled with zombie businesses.

Words by
Jessica Sier Right Chevron

Jessica Sier is a financial journalist who currently heads up Spaceship's content. Prior to that she was a reporter at the AFR where she discovered breaking down financial bulls**t was a public good.

Understanding active vs passive investing