Active vs Passive Investing: What are the main differences and which approach offers the better returns?

Highlights

• Active investing is a hands-on approach that aims to beat the market or outperform a certain standard benchmark by taking full advantage of short-term price fluctuations. Portfolio managers conduct an independent assessment of each investment’s worth so that they can select the most attractive option.
• Investing in a hedge fund that is highly leveraged and is focused on absolute returns as opposed to following the benchmark performance is one example of active investing.
• With the possibility for higher-than-average returns, access to a professional and a certain level of flexibility, amongst other things there are several benefits to this approach.
• However, having a professional oversee your portfolio comes at a cost, while the potential to generate higher returns also carries a higher risk.
• Passive investing aims to match the broad market performance, while it focuses on the long-term. As a result, it is considered as a buy-and-hold approach which ignores short-term market ups and downs.
• An index fund that follows one of the major indices such as the S&P 500 or the Dow Jones Industrial Average (DIJA) is an example of passive investing.
• Taking a passive investing approach can be a more affordable way of accessing the markets since you can limit fees associated with an active fund manager. Typically, there is more transparency over your investments, whilst it can be a more tax-efficient option.
• Yet, seeing that core holdings are locked in to track the market, returns may be smaller, while the fact that you are limited to a specific index or predetermined set of investments means that passive investing offers little variety.
• From the investment objective to the transaction frequency, the portfolio composition and whether focusing on the long-term or short-term, there are several key differences between active and passive investing.
• Wondering which of these strategies generate better returns? It doesn’t have to be an either-or choice. A mix of both active and passive investing across different asset classes and market conditions may be the optimal alternative for your portfolio.
• Looking for an advisor to build a diversified portfolio that includes both active and passive investment strategies? Qualified and boasting a wealth of experience, Calamatta Cuschieri’s advisors can address clients’ unique needs and draft a customised financial strategy, whilst acting in the best interest of clients.

One of the foremost issues encountered while constructing investment portfolios is the type of strategy to be used while choosing investments and whether this should be active or passive. Whereas one aims to beat its underlying benchmarks and potentially offer greater returns, the other focuses on matching the broad market performance. Each with their own merits and shortcomings, active and passive investing strategies have often fostered a heated debate in the financial world.

Here we break down the two approaches and how they differ in their objectives and tactics, while we analyse why both strategies can have a role in your portfolio.

What is active investing?

A hands-on approach that aims to beat the market or outperform a certain standard benchmark, active investing requires a portfolio manager who can take full advantage of short-term price fluctuations and who can conduct an independent assessment of each investment’s worth so that ultimately, they can select the most attractive option. Securities are bought and sold often based on daily fundamental company research, historical earnings and an analysis of the underlying industry. Whereas some portfolio managers specialise in picking individual stocks they believe will outperform the market, others invest in sectors or industries they think will do well.

If we assume that your goal is to achieve better returns than the S&P 500, then actively investing in a hedge fund that involves high levels of leverage and is focused on absolute returns as opposed to following the benchmark performance can help you achieve your objectives.

What are the advantages and disadvantages of active investing?

With active investing professional investment managers pick the right investments on behalf of investors. When things go well, this approach can deliver good returns and this together with other advantages make active investing appealing. However, just like any other investing approach, there are drawbacks, such as the fact that there is no guarantee the desired performance will be delivered. Below are some more advantages and disadvantages.

Advantages

• Higher-than-average returns: with the aim to beat the market, if successful, this can translate to better returns.
• Flexibility: seeing that investment managers are not required to follow a specific index, they can select any type of stock or other instruments available in the market they believe have the potential to offer good returns.
• Access to a professional: knowledgeable and experienced, a professional portfolio manager does not only look after your investments, does the necessary research and keeps close tabs on the markets on your behalf, but they may also expose you to investing products you may not have thought would be to your advantage.

Disadvantages

• Costs: having a professional oversee your portfolio may put your mind at ease, however, this comes at a cost since it often involves transaction and research-related costs.
• Active risks: Despite the potential to generate higher returns, active investing carries a higher risk. For instance, your portfolio manager could misjudge the market and select underperforming stocks.

What is passive investing?

A more balanced investment approach that aims to match the broad market performance, passive investing focuses on the long-term and on a buy-and-hold approach, while it resists the temptation to react or anticipate the stock market’s next move. At the same time, passive investors limit the amount of buying and selling within their portfolio and in turn, the costs associated with frequent trading or research analysis. What’s more, it is a strategy typically preferred by those with a lower risk tolerance.

A simple example of passive investing is buying an index fund that follows one of the major indices, such as the S&P 500 or the Dow Jones Industrial Average (DIJA). Your fund manager switches holdings based on the changing composition of the index being tracked by the fund. So if, for instance, the S&P 500 changes its constituents, then the index fund that follows it will automatically switch its holdings by selling the stock that is leaving the index and buying the stock that is about to become part of the index.

What are the advantages and disadvantages of passive investing?

Passive investing’s set-and-forget approach, together with its relaxed nature can be an advantage in itself for some investors, however, there are other benefits worth considering. On the other hand, it does have its limitations as outlined below.

Advantages

• Low fees: passive investing can be a more affordable way of accessing the markets since you can limit fees associated with constant stock picking.
• Transparency: there generally is complete transparency over your investments, which means that you will know exactly where your money is.
• Tax-efficient: seeing that annual capital gains are not expected to be massive, this approach can be more tax-efficient.

Disadvantages

• Smaller returns: passive investing does not seek to beat the market, while core holdings are locked in to track the market, which means that returns are generally smaller.
• Limited choice: tied to a specific index or predetermined set of investments, passive investing offers little variety and so investors are locked into specific holdings no matter what happens in the market.

What are the key differences?

Below is a snapshot of some of the key differences between active and passive investing:

	ACTIVE INVESTING	PASSIVE INVESTING
Investment objective	To beat market performance with a focus on absolute returns. Investing is based on independent analysis of each investment.	To match the market performance with a focus on relative returns. The portfolio is formed by matching the market portfolio.
Transaction frequency	Relatively high with a lot of buying and selling.	Comparatively lower and any switching in holdings is based on changes in the index composition.
Long-term vs short-term	Seeks to take advantage of short-term price fluctuations.	A focus on long-term investing.
Costs involved	Higher operating costs.	Potentially lower operating costs and more tax-efficiency.
Portfolio composition	Fewer securities than a broad market index.	All securities of a market index held to match market performance.
Expertise required	Appropriate skills needed to identify price discrepancies and arbitrage opportunities, ability to conduct fundamental and technical assessment of stocks.	Requires little decision-making by the investment manager. More time savings due to less research and analysis required.

Examples of active and passive investment approaches

Active investing is followed across a number of instruments. Here are just some examples.

Hedge funds: with these types of funds, a portfolio manager actively tries to outplay the markets.

Mutual funds: the objective here is to outperform index funds.

Day traders: these actively buy and sell on the market on their clients’ behalf.

Wealth managers: these are hired by individuals to manage their portfolio with capital invested by the client.

On the other hand, passive investing can take several forms. These may include:

Index funds: these track several companies across a given stock market index and may also include some mutual funds.

ETFs: most ETFs are considered passively managed funds. One example of an ETF is the Vanguard S&P 500 ETF (VOO).

Which of these strategies offer better returns? For most people, there is a time and a place for both active and passive investing over their lifetime, often depending on the financial milestones they would like to achieve. As mentioned earlier on, active investing has the potential to earn higher returns compared to the market, however, doing so comes at a cost, taxes and time dedicated for research, while it may involve higher risk. On the other hand, passive investing has the potential to consistently earn the equity risk premium with a low-cost exposure and less research, however, it ignores the market fluctuations and as a result, the possibility of earning higher returns and outperforming the benchmark.

Typically, retail investors, in other words, non-professional / non-discretionary investors, prefer passive investing due to the fact that they would rather leave the day-to- day and active management of their investments in the hands of experienced and qualified fund managers. However, investors always have a choice on how to best diversify their investment portfolio.

In essence, it does not have to be an either-or choice. Investors can make the most of their money through a mix of both active and passive investing approaches across different asset classes and market conditions. As always, consider your financial situation, your life stage, as well as your ability to tolerate risk before taking any decision.

Looking for an advisor who can help you build a diversified portfolio that includes both investment strategies? Qualified and boasting a wealth of experience, Calamatta Cuschieri’s advisors can address clients’ unique needs and draft a customised financial strategy, whilst acting in the best interest of clients. At the same time, they have access to a full range of investment products which means that they can directly invest in the markets. Here are some of the benefits on enlisting an advisor’s help:

Bespoke advice

By actively taking into consideration the complexities of your finances, your personal circumstances, as well as your short and long-term objectives, our advisors can provide the necessary advice and work with you to establish investment decisions with your best interest in mind.

Peace of mind

With our financial advisors you are safe in the knowledge that an experienced professional is taking care of a wide range of challenges on your behalf, keeps close tabs on the markets, while conduct thorough research to identify the best investment opportunities.

Transparent and clear

Thanks to our simple and easy to understand fee structure, not only you’ll know exactly what you are paying for, but it is also highly competitive and transparent. We do not charge annual management fees, custody fees or any other hidden, recurring fees.

Have a look at the right questions to ask before making any investment.