When it comes to investing, there are two main types of management strategies active and passive investing. Both approaches help you reach your investing goals, but in different ways, and there’s a hot debate over which is better.
In this blog article, we’ll help you understand the concepts behind each investment approach, their advantages and disadvantages, and the factors you need to consider when choosing an approach. Last but not least, we’ll share some tips on how you can make sure the approach you have chosen works for you.
Active investing follows a more “hands-on” approach than passive investing and it involves the active selection of assets based on an assessment of each investment’s value, to choose the most attractive ones. This is usually done by an asset manager and involves a lot of research and expertise to take advantage of market price fluctuations. The ultimate goal is to “beat the market” or outperform certain standard benchmarks.
The Advantages of Active Investing
It is possible to outperform the market (or its benchmark) and in doing so, generate alpha.
Active investors can invest freely since they are not tied by an index. This means that the particular investor’s requirements, ethical or other, can be accommodated.
Hedging through certain financial instruments (e.g. options); asset allocation models; minimizing potential losses by avoiding certain sectors, regions, etc.
The Disadvantages of Active Investing
Higher transaction fees due to more buying/selling; management fees for asset management.
An active manager can freely buy/sell assets that they think would bring high returns, but in reality, the market is very difficult to predict and there’s no guarantee of the returns.
Performance depends on the skill of the manager.
Passive investing, on the other hand, has a more back-seat approach with limited trades. It is more of a “set it and forget it” way of investing.
Generally, passive investors believe that it’s hard to beat the market, but in the long term, you can get a steady return with lower fees and less effort.
Passive investors track indexes through ETFs (Exchange Traded Funds), which are groups of securities that are alike in some way. Buying an index fund or an exchange-traded fund that owns every stock in the S&P 500, for example, is a passive investment.
The Advantages of Passive Investing
Lower transaction fees due to less buying and selling; no asset management fees.
You know what you are getting.
Depending on your tax residence, it might be more tax efficient and less likely to incur taxes during the holding of the investment.
Risk is lowered through diversification.
The Disadvantages of Passive Investing
It can be too limited, and the investor cannot directly influence the individual choice of assets – since the investor invests in a market/index regardless of their ethical standards, etc.
As an investor, you will at best do as well as the market, with no chance of outperforming it. Normally, the fees inherent in an ETF will result in the ETF’s performance being very close to the performance of the benchmark. It is more of an anomaly if the ETF outperforms its benchmark. Big differences between the ETF’s performance and the benchmark are a warning sign of a covertly active investment style.
“Big differences between the ETF’s performance and the benchmark are a warning sign of a covert active investment style.”
Which Investment Strategy Should I Choose?
The decision of which approach to choose is not a simple one and there are many variables to consider:
Are you prepared to take higher risks in exchange for higher returns, or do you prefer security with lower but steady returns?
Are you prepared to spend the extra money required for an actively managed portfolio?
Do you have the time to actively manage a portfolio?
Ethical or other preferences
Do you want to have the opportunity to freely select the assets you want to include in your portfolio?
Size of the portfolio
The larger the portfolio, the more advantages an active style has, which brings us to the question: at what point should I consider an active investment style?
High-net-worth individuals typically work with asset managers who actively manage their investments.
However, both active and passive investments can play a role in a well-diversified portfolio and yes, a mix of the two is not only possible but can be a very good strategy as well.
A key factor when choosing the active and passive part of your portfolio is getting an understanding of where your asset manager’s expertise lies. At the end of the day, we are all human and we all do some things better than others. For example, there are asset managers who have a real edge in managing equity portfolios but are not exceptionally good when it comes to fixed-income investments. In that case, you would want to allocate the equity part of your portfolio to an actively managed mandate – and the fixed income portion might be better off with an ETF (passive investment strategy).
Or you might want to find that asset manager with an edge in fixed-income portfolios, so you can have all of your assets actively managed with the potential to outperform the market and generate alpha.
How Can We Help?
The key question at the heart of the active vs. passive investing debate focuses on the ability of asset managers to beat their underlying benchmarks.
How do you make sure your investment is managed well, and in line with your goals and preferences?
We believe that there are certain actions you can take to determine whether your asset manager can time the market and outperform the underlying benchmark.
Make sure that you are getting your money’s worth
The pressure on asset managers to perform well to justify high fees has become even greater over the last few years. As a result, some asset managers’ investment styles tend to mimic/follow the benchmark too closely to limit some of the risks of underperforming.
This presents a major concern: are costly asset management fees justified if the asset management style mirrors index performance? The answer is: certainly not. In that case, the manager is unable to generate any alpha and brings you the same returns as index funds or ETFs – but for twice the cost.
There are several things you should look out for to make sure your asset manager is not a benchmark hugger.
The simplest way to do that is to see if he/she:
- holds stocks outside the benchmark
- holds stocks from the benchmark, but with different weights: for example, he/she holds a stronger concentration of smaller companies or invests in only a few of the index companies
- has convictions that change when markets turn (hint: the convictions shouldn’t change as fast as the market moves)
Make sure you are paying a fair fee considering the size and structure of your portfolio
High fees are considered one of the top disadvantages of having an asset manager.
Calculations are based on the following assumptions:
the portfolio consists of several asset classes, some of which are active and others passively managed;
passive investments don’t require the asset manager’s constant attention, thus a smaller fee is estimated
taxes (turnover tax, fees from stock exchanges) are excluded from the calculations
custody fees if the bank holding the assets acts as an asset manager, then the calculated fees include custody fees (all-inclusive fees). If you have an external custodian a maximum of 0.1% fee should be added to the calculation.
“You don’t want to be paying full management fees if 60% of your portfolio is allocated to passively managed funds.”
Pay attention to the management fees you are being charged and revise them regularly. Portfolios change their structure over time and the allocation of actively and passively managed investments can also change. You don’t want to be paying full management fees if 60% of your portfolio is allocated to passively managed funds.
Get a better understanding of your asset manager’s style and performance abilities
How do you make sure your asset manager can time the market and take advantage of current market conditions?
There are several analyses we provide our clients with which can give you a very good insight into the management style and performance of your asset manager.
Up and Down Capture
Up and down capture is an analysis that helps you evaluate the asset manager’s performance against the fluctuations in the market and his/her ability to outperform the benchmark. This analysis is also very useful in identifying the asset managers’ style. For example, an aggressive manager will make larger gains when the benchmark is moving up, but also bigger losses when the benchmark is moving down.
Tracking error is an analysis that measures the closeness with which the asset manager can follow the benchmark, by measuring the statistical difference between the portfolio’s performance and the benchmark’s performance.
Managing a portfolio successfully is a very challenging task with many variables to take into consideration. The current uncertainty in the market requires having better tools and controls in place to make sure your portfolio is generating the returns you are aiming for.
In a nutshell, the general recommendation when choosing which strategy to choose for your wealth is:
If you don’t wish to pay costly asset managers fees (and you don’t want to manage it yourself), or you cannot commit to the time and involvement required to successfully navigate a portfolio, go for passive investment through ETFs. Ideally, big ETFs follow well-known markets (S&P, NASDAQ, EURO STOXX, etc.)
If you decide to actively manage your wealth think about the investment policy statement and the expertise of the asset managers you currently have. Allocate active mandates only in the discipline that the manager does very well and consider having the rest run with ETFs (or similar tools). Or, look out for an asset manager who can successfully manage the rest of your portfolio, because it is always best to have an active mandate which can outperform the market and the benchmark.