Active versus Passive Investing – What’s the difference and what’s the best?

Investing in shares is a popular way of helping people to achieve their long-term financial goals.

These investments can generate favourable returns over time as companies grow and improve their profitability. Dividends paid by listed companies can also generate a useful income stream.

However, there are also risks associated with investments in shares. Companies (or stocks) that struggle are likely to see their share prices fall and share markets as a whole can be affected by periods of economic weakness or unexpected events.

All investments carry risk, including those in professionally managed funds. However, exposure to shares in such funds may be one way that investors can navigate the volatility in markets.

These funds are usually well diversified, spreading investment risk across a wide range of companies. There are two distinct types of funds available to investors – active funds and passive funds.

What is Active Investing?

Most actively managed funds aim to outperform a particular index – for example, the S&P/ASX 200 Accumulation Index, which represents the top 200 stocks listed on the Australian share market.

The intention is that the combined portfolio of shares will perform better than the relevant index, which is often used to ‘benchmark’ or measure the performance of stocks.

Investment managers of funds have access to the information and research necessary for completing detailed analysis on companies traded on the index. As qualified professionals, they can identify the stocks likely to outperform the market average over time.

With robust investment processes not readily available to individuals, active investment managers draw from their industry experience and analysis to buy and sell shares in an effort to maximise returns for investors.

They buy stocks that are expected to perform better than the broader market, sell winning stocks following a period of favourable performance, and avoid those that are expected to underperform.

Of course, investments can experience day-to-day fluctuations, and there is also a risk that active funds will underperform compared to the benchmark if the selected stocks do not perform as well as investment managers anticipate.

While the value of a benchmark fluctuates from day to day, the extent to which returns vary from those of a benchmark can be an indication of a manager’s skill.

What is Passive Investing?

A passive investment manager tries to replicate a share market index, such as the ASX 200, by owning shares that make up the index. The quantity of each stock held is determined by the stock’s weight in the index.

For example, if BHP Billiton accounts for 6.7% of the ASX 200, a passive fund manager will invest 6.7% of the fund in that stock, and so on, for every stock in the index. The investor should expect returns to be close to that of the market index.

Which Type of Fund is Right for You?

One approach is not necessarily better than the other. When deciding on a preferred style of investment, investors should first consider their investment objectives, return targets and how much they want to pay.

Many investors expect to receive returns that are above that of a market index and may therefore prefer investing in an actively managed fund. In this case, choosing an active investment manager can be important and a key consideration for investors is their confidence in a manager’s ability to achieve their investment objectives.

While past performance is not necessarily an indication of future performance, most investors will consider a manager’s long-term performance track record before making an investment in a fund.

Cost can be another differentiator of the two styles. Actively managed funds typically have higher management fees to cover the cost of research and to pay for the employment of experienced analysts as part of the fund management process.

In contrast, management fees for passive funds tend to be much lower.

That’s because no attempt is made to outperform a benchmark index through research or stock selection.

Source: Colonial First State