Active Vs. Passive Investing


Active Vs. Passive Investing

One of the first questions any investor must ponder is whether to adopt an active or passive investing approach. Here we examine the key strengths of these two strategies and the differences between them.

Published on 7 September 2017

Investing is a powerful vehicle that can put you on the road to achieving long-term financial security and success. Whether you are an aggressive trader, a conservative investor, or somewhere in between, it is essential to build a diversified investment portfolio to minimise risk and maximise profitability.

While there is an overwhelming array of investment products to choose from these days, the overarching strategy in approaching them can easily be classified into two main categories: active and passive investing.

Active investing is a hands-on approach that aims to outperform the market by advocating significant trading activity and ongoing buying and selling actions. It requires the investor or professional portfolio manager to monitor the market closely and actively buy and sell stocks and other securities to exploit profitable conditions and reap short-term profits.

Passive investing, as its name suggests, is focused on achieving long-term portfolio growth while keeping the number of buying and selling activities to a minimum and resisting the impulse to react to the regular spikes and dips in the market. For example, the “buy-and-hold” approach is a classic passive investment strategy.

Key strengths

The biggest advantage of active investing is that it gives investors the freedom to analyse and assess the market and the power to make instantaneous buy-and-sell decisions in order to profit from short-term price fluctuations.

Actively managed funds also offer a greater degree of flexibility than passively managed funds. Active investors are well positioned to capitalise on market trends by buying potential high-growth stocks, selling particular stocks that become too risky due to prevailing market conditions, and investing in specific stocks that will help mitigate losses during downturns. Active managers can also employ various investing tricks and techniques such as short-selling and put options.

Needless to say, this hands-on stock picking approach is more time-consuming and requires a lot more knowledge, research, and effort than passive investing does. Perhaps this is one of the reasons why passive investment strategies have grown in popularity among investors in recent years, with nearly US$500 billion of new investment flowing into passive funds in the first half of this year alone, according to Bloomberg.

Index funds are huge favourites among passive investors as they offer the opportunity to invest in a wide selection of stocks without having to purchase them individually. The Straits Times Index, for example, is a blue chip index made up of the top 30 companies listed in the Singapore Stock Exchange (SGX). Index funds are designed to match or track a particular benchmark index, enabling investors to easily build a low-cost, diversified portfolio that basically replicates market returns over the long haul.

Exchange-traded funds (ETFs), a subset of index funds, are another popular passive investment choice. Basically, ETFs are funds that comprise a basket of securities listed and traded on the stock exchange, giving investors exposure to an entire market or market segment. ETFs offer trading flexibility as well as low management and transaction costs.

It is important to note, however, that although investors in index funds and ETFs can reduce the risks that arise from being overly exposed to a particular stock, these funds are not principal-guaranteed, and are susceptible to market fluctuations just like actively managed funds. Additionally, as their core holdings track the movement of a particular benchmark index, passive investors will seldom outperform the market and earn massive returns unless the market itself booms.

Key differences

Cost is usually the most obvious difference between active and passive investing. Active investing generally requires a higher volume of buying and selling, and thus involves higher transaction costs, commissions, and advisory fees. Cost-sensitive investors usually prefer passive investment as it limits the amount of buying and selling, dramatically reducing the fees that result from frequent trading.

Another key difference is that passive investors are typically locked into a specific index or predetermined set of investments, and are thus not able to react swiftly to market changes to protect themselves or take advantage of opportunities. Passive investments simply seek to replicate the market’s long-term returns and eliminate the complex guesswork of market timing.

Active investment, on the other hand, attempts to predict the market and select the most profitable securities, stocks, bonds, or any assets based on market performance, extensive research and analysis, and the portfolio manager’s expertise. Consequently, the risks of active management can be high, and poor judgement can prove to be a costly mistake – but the rewards for choosing the right investment can be high as well.

The bottom line

Both active and passive investment strategies have their advantages and disadvantages. Hence, it is important for investors to build a balanced portfolio that combines both approaches so as to enjoy the best of both worlds. This two-pronged approach will further diversify an investor’s portfolio and better manage its overall risk.