The debate between passive and active investors has gone on for decades, and we aim to explain the key features of both approaches.
Over the past couple of decades, index-style investing has become a popular strategy for investors who are satisfied with duplicating broad market returns instead of trying to beat them.
There are plenty of indexed mutual funds and exchange-traded funds which track the broad market as well as narrower sectors such as small-company stocks or specific industries.
Generally, passive investors will use exchange traded funds (ETFs) which are funds listed on the share market which track the performance of a market index. There are some key advantages of passive investment:
1) Passive funds generally have low fees
2) There is a high level of transparency -because investors always know what stocks an investment contains.
Active management varies to degrees, however in general the aim of active management is to outperform the broader market and add value for investors.
There are 2 key ways in which active investing can add value:
1) Security Selection–this refers to aiming to buy stocks which will perform well (and better than the market) and selling or not owning stocks which will perform poorly.
2) Tactical Timing–this refers to moving between different types of assets, depending on the portfolio manager’s view. For example, an active portfolio may hold cash if the manager believes share markets are set to fall and wants to avoid downside.
This leads to the first significant advantage of active management –the potential to preserve capital. Studies have shown that avoiding significant downside events is the biggest contributor to outperformance over the long term. The recent Global Financial Crisis (GFC) was a prime example where many fund managers saw it coming and allocated heavily towards cash rather than shares. This action saw these funds avoid significant downside and outperform the broader market.