The debate between active and passive investing has existed for decades, but has recently come again to the center of attention as many passive funds post high returns and evidence show capital flowing from active into passive funds. But what exactly is the difference between active and passive investing? Here, we’ll discuss a general overview of what defines active versus passive investing, and common arguments in favor of and against each investment strategy.
What is passive investing?
Passive investing, otherwise known as index investing, occurs when the investment portfolio mirrors a market index, such as S&P 500. This strategy is commonly employed by mutual funds (such as Vanguard) and Exchange Traded Funds (ETFs), though in recent years some active ETFs have been established.
The key philosophy behind passive investing is the efficient market hypothesis. Simply put, this hypothesis argues that stock prices always correctly reflect the fundamental value of a stock, incorporating and reflecting all relevant information. Under this argument, it is impossible to outperform the market in the long run. Therefore, it is more profitable to create a portfolio that mimics an index.
What is active investing?
In contrast, active portfolio managers (such as Fidelity) choose to purchase stocks and other investments and continuously monitor the activity of these investments to take advantage of profitable conditions. These investors use financial models, fundamental research, market forecasts, and personal experiences to make decisions regarding which securities to buy, hold, and sell. Active managers watch the markets very closely – even the smallest variations in market prices can result in an opportunity to profit!
The goal of active managers is to exploit these short-term variations in the markets to produce returns better than those of passive funds that mark to an index. This is also known as “outperforming the market,” which goes against the basis of the efficient markets hypothesis discussed earlier. Active investors believe that stock prices do not always accurately incorporate all relevant information and reflect the fundamental value of that security. These price discrepancies from the fundamental price are exactly the source of return for active managers.
Passive vs active investing: the debate
The debate between passive and active investing has existed for a long time, and stems from arguments regarding the viability of the efficient markets hypothesis. Those in favor of active management argue that active investing, when done well, does indeed outperform the indices. In addition, active investors have increased flexibility in choosing which stocks to hold, can manage risks through hedging and selling stocks when risks increase, and allows for elite portfolio managers to exploit informational advantages to maximize returns.
On the other hand, in recent years, arguments for passive investing have become increasingly prevalent as empirical data suggests that active investing on average has not outperformed the market. For the typical individual investor, passive investing is advantageous in its minimal fee structure, since there is no need to pay a portfolio manager to research and select which stocks to buy. In addition, the composition of a passively-invested portfolio is very transparent – investors always know which securities are an index. Given these advantages, many argue that the after-tax and post-fee returns in passively-managed portfolios actually surpass the returns seen in active management.
With this understanding of the two broad categories of investing strategies, you can better understand which strategy better fits your personal preferences. When choosing to invest your own money, make sure to do your research before deciding what type of fund you want.
Siyu Wu is from Colorado and attends Princeton University, pursuing a degree in Economics and certificates in Finance and East Asian Studies. Siyu will graduate in 2018. She hopes to synthesize her interest in China and East Asia with her passion for finance to eventually work in a career related to international finance and Asian capital markets.