Difference Between Active vs Passive Investing
One of the foremost issues encountered while constructing investment portfolios is the strategy to be used while choosing investments: whether to use active investing or passive investing. Active investing involves being more aggressive in investment approach and hence would entail higher returns compared to passive investing. While it may seem more logical to go for active investing, there are merits in passive investing as evidenced by the growing popularity of the later strategy over the past decade.
Underactive investing, investments are selected based on an independent assessment of the value of individual investments and an investor is always on the lookout for short-term price fluctuations. It involves extensive fundamental and /or technical analysis and micro and macroeconomic factors influencing the investment are closely monitored. The objective of active investing is in outperform the market. At the extreme end of the spectrum, you will find hedge funds which embark on very aggressive investing involving high levels of leverage and focus on absolute returns rather than following the benchmark performance. Clearly, this involves high risk since there is always the possibility that the investor’s/fund manager’s viewpoint will not materialize. You need to be very good at picking up the right stocks at the right time. Also, this takes up considerable time to track the best investments and high level of expertise and risk-taking attitude.
Passive investing is a more balanced investment approach aimed at matching the broad market performance. Passive investing has a long-term focus and ignores short-term market ups and downs. A passive investor limits the buying and selling activities in his portfolio in response to changing composition in the tracked index to be matched. This is thus a more cost-effective way to invest and avoids short-term temptations or setbacks in price. A good example of passive investing is buying an index fund wherein the fund manager switches holdings based on changing composition of the index being tracked by the fund. The fund strives to match the index return rather than focusing on absolute returns.
Active vs Passive Investing Infographics
Below is the top 10 difference between Active vs Passive Investing
Key Differences between Active vs Passive Investing
Both Active vs Passive Investing are popular choices in the market; let us discuss some of the major Difference Between Active vs Passive Investing:
- Active investing is an investment approach involving extensive research while choosing investments with the objective to beat the broad market index. Passive investing is an investment approach which chooses all the investments that constitute the broad market index (selected) with the objective of matching the broad market (selected index) performance
- Active investing involves fundamental/technical analysis for picking up investments. Passive investing involves picking up investments based on a composition of the market index which is comparatively a less risky approach to investing
- Active investors consider markets as inefficient and are more interested in taking advantage of short-term price fluctuations while passive investors consider markets as efficient, hence they ignore short-term fluctuations and have a long-term buy and hold strategy.
- Active investing involves a high volume of transactions due to frequent buying and selling activities, hence the operating costs and capital gains taxes are high. Passive investing involves a comparatively lower volume of transactions, hence is more tax efficient and involves lower operating costs
- Active investing could involve a range of strategies consisting of shorting, borrowing money for investments, using derivatives for hedging/speculation, arbitrage etc. Passive investing requires limited use of strategies while matching the benchmark returns
Head to Head Comparison between Active vs Passive Investing
Here are some of the Comparison between Active vs Passive Investing –
|The basis of Comparison Between Active vs Passive Investing||
|Meaning||Investing based on independent analysis of the value of each investment||Investor portfolio is formed by matching the market portfolio|
|Investment objective||To beat the market performance, focus on absolute returns||To match the market (tracked index) performance, focus on relative returns|
|Investor perception of a market||Perceive markets to be inefficient||Perceive markets to be efficient|
|Transaction frequency||Comparatively higher with a lot of buying and selling||Comparatively lower, switching holdings based on changes in index composition|
|Risk-Return Trade-off||Higher returns but more risky||Lower returns but less risky|
|The cost involved||Higher operating costs||Comparatively lower operating costs, tax efficiency|
|Long term vs short term||Takes advantage of short-term price fluctuations||Ignores short-term fluctuations, long-term investment focus|
|Expertise required||Superior skills needed to identify price discrepancies, arbitrage opportunities, fundamental /technical assessment of stocks||Requires little decision making by a manager, time savings due to less research and analysis involvement|
|Portfolio composition||More concentrated portfolios with fewer securities than a broad market index||All securities of market index held to match market performance|
|Flexibility in investing||Highly flexible involves strategies like shorting, use of derivatives, hedging, leverage, arbitrage etc.||Low flexibility, the strategy involves buying and selling based on changes in index composition, suffers from market volatility due to limited use of strategies|
In this Active vs Passive Investing article, we have seen Active investing has the potential to earn higher returns compared to market but this involves higher costs, taxes and time for research alongside higher risk involved due to uncertainty in realizing the expectations from investments. In contrast, passive investing has the potential to consistently earn the equity risk premium with a low-cost exposure and less research involved in matching the market portfolio but this approach ignores the market inefficiencies and hence a possibility of earning higher returns and outperforming the benchmark.
Most investors prefer to invest with a long-term objective and avoid timing the market due to the high cost and high-risk involvement. These investors may prefer an actively managed fund only when they are confident about the fund manager’s expertise in active investing. However, history reveals that many active investors failed to outperform the market (or equivalent passive investing portfolio) after accounting for the high expenses. The popularity of passive investment has grown over the years.
It has been witnessed that consistently achieving success in active investing is difficult for some asset classes like the large-cap stocks, hence it pays to be a bit more passive in those investments. Opportunities for active investing are more in case of small-cap stocks. Again, during market stress, actively invested funds have higher flexibility in adjusting their portfolios to lower the losses.
Investors can get the best of both through a mix of both active vs passive investing approaches across different asset classes and market conditions. The proportion of active vs passive investing would depend on their objectives, investment timeline, and risk-taking ability.
This has a been a guide to the top difference between Active vs Passive Investing. Here we also discuss the Active vs Passive Investing key differences with infographics and comparison table. You may also have a look at the following articles to learn more –