What Is Passive Investing? Pros and Cons vs. Active Investment

Updated on May 12, 2018
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Cruncher is the pseudonym of an actuary working in London with experience in insurance, pensions and investments.

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Investing is hard and difficult to do well, partly because as human beings we are not really as rational as we like to think. So choosing a good investment strategy and sticking to it are important.

There are lots of different ideas about how to make money from investments, in other words, lots of different investment strategies. The different mutual funds or investment trusts that you can invest in as a retail investor will each have their own strategy. But in general there are two kinds of investment strategy - active or passive.

Note: "Passive investing" is not the same as "passive income."

What Is a "Passive Investment" Strategy?

A passive investment strategy is one that doesn't try to pick specific assets, like Microsoft shares or Japanese government bonds, to invest in. Instead they invest in all the available assets in a given market. For example, a fund passively investing in Japanese equities would buy all the shares listed on the Japanese stock exchange.

The fund will allocate itss money between the different specific assets (eg different shares in the market) depending on the total market value of the asset relative to the market as a whole. For example if Microsoft shares are worth 5% of the total value of the shares available in that market, then a passive strategy would mean spending exactly 5% of your fund on Microsoft shares. This means that as the value of assets change the passive fund will need to be rebalanced.

Using a passive strategy means that you will get the (weighted) average return on all the assets in the market. Having such a well-diversified strategy should also reduce the variability of your returns compared to investing in only a few assets.

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How an "Active Investment" Strategy Differs

Active investment strategies are the opposite of passive ones. With an active strategy the fund manager (which could be you yourself, if you prefer) tries to do better than the average return on the whole market by "picking winners". The fund manager will have ideas about which assets are undervalued or overvalued or have some other plan of how to beat the market as a whole.

Active investment funds are almost always more expensive than passive ones as they take more research time, and there will also be extra costs if they buy and sell shares more often than passive funds.

And although it's true that higher expected investment returns have to be paid for with higher risks, higher expected returns don't necessarily require higher costs, because not everyone has to pay the same management fees.

Which is Better: Active or Passive Investment Strategy?

There is a fundamental problem with investing in actively managed funds. Passive funds will give you a return on your investment (roughly) equal to the return on the whole market for their kind of investments (in other words for the "asset class"). The average return on all the actively managed funds and private investors must also be equal to the return on the whole market. That means if some investors do better than average, others must do worse than average.

This, then, is the problem: How do you know which actively managed funds are going to do better than the market average? Answer: You don't. You can see if you agree with their investment philosophy, you can look at past performance - but even then, how do you know if that past performance was just a fluke? See the example below.

Actively managed funds cost more than passive funds (because they involve more work). So, even if you can be sure your actively managed fund will do better than average, will it do well enough to make up for charging you more?

On the other hand, there may be very clever people who get their guesses about the future of the markets right more than half the time. If there are such people, why not use their expertise to make more money from your investments? You wouldn't want to miss out.

Asset Allocation - The Other Key Question

Whether you have passive investments or actively managed funds asset allocation is very important. That means choosing the types of investment you have in your portfolio and in what amounts. For example you might decide to have half your portfolio in corporate bonds and half in shares, or a quarter in commercial property and three quarters in government bonds.

The important thing in asset allocation is to make sure that the types of investment you have in your portfolio are suitable for you: suitable for your needs and suitable for the amount of risk you are willing to take with your hard earned money.

Don't trade your portfolio too often or your profits will be eaten up in fees but it can be a good idea to use the magic of rebalancing to buy low and sell high. Never a bad way to make money.

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Example: Can We Be Sure Succes in Active Investing Is Not Just a Fluke

Imagine there are 100 fund managers. Every year, by definition, half of them will be in the top 50% of managers. Over five years, what is the chance that manager would be in the top half purely by chance? It's 1/25 = 3.125%. So not impossible but a pretty small chance.

On the other hand what is the chance that there will be at least one manager who is above average every year just by chance? That is 1 - (1-3.125%)100 = almost 96%! It's almost guaranteed that somebody will beat the market every year even if the whole industry operates purely by chance.

This doesn't prove that it is pure chance, of course. It just means it's very hard to show that it isn't!

So What Should I Do?

There is, unfortunately, no simple answer. This controversy will continue to run. Fortunately we don't have decide the academic argument here and now. All you need to decide is two things:

1. Are there active managers out there who can regularly beat the market with a better than fluke record?

2. If so, can I reliably fund out who they are?

If you answer yes to both of those then invest in those active funds you've found. Otherwise you'd probably be better off with passive funds—after all, you don't want to pay more for something if you don't think you'll see any benefit.

Conclusion

There isn't one. Well, not a simple one. No one can prove whether actively managed funds are worth it compared to passive ones.

But so long as you understand what you are investing in and what you are paying for, you can decide if it's worth it.

Happy investing.

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