Active vs Passive Investing - What Is Index Investing?

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Active vs Passive Investing - What Is Index Investing?

DIFFERENCE BETWEEN ACTIVE INVESTING & PASSIVE INVESTING

The main difference between Active and Passive Fund Management lies in how active and passive investment strategies are implemented.

Active Fund Management:

⦿ Actively managed fund attempts to beat market performance through superior security selection. That is to say; active investments fund manager tries to pick the stock that will perform much better than the market average. 

⦿ In other words, this fund manager is looking to select the winning stocks, as these companies will presumably outperform their peers. There is a theory that allows managers to contemplate stock picking as a viable way of improving a portfolio's performance.

⦿ The line of thought rests on the idea that markets are inefficient, and there are time lapses between data, news or headlines being released and the subsequent change in price needed to reflect the new information.

⦿ Skilful managers, therefore, are capable of taking advantage of market inefficiencies and improve on the broad market performance.

Passive Fund Management:

⦿ Passively managed funds track the broad market usually represented by an index. Passive fund managers do not attempt to outperform the market; in general, passive fund managers strive to have a portfolio that best reflects a broad market index.

⦿ The thought behind passive investment strategy is that a broad and well-diversified portfolio greatly reduces the risks involved with stock picking. It also means that passive investment funds portfolio will mimic the returns achievable by the index.

⦿ Why does the stock market as a broad asset class creates positive returns? The theory behind this question is that investors need to be rewarded for the risk of holding corporate stock. This security is last in line to be paid out in the case of bankruptcy, pays variable dividends and is subject to various risks.

⦿ However, stocks are also the asset class which best holds the value of a corporation, as the company's value increases so does the value of its shares, in this way investors receive their compensation for holding stocks.

WHAT IS INDEX INVESTING?

Index Investing is passive investment strategy to build a broad and well-diversified portfolio which greatly reduces the risks involved with stocks to invest in. Passive investment portfolio will mimic the returns achievable by the index.

ACTIVE FUND MANAGEMENT INVOLVES GREATER RISK, NOT NECESSARILY GREATER REWARD

With passive portfolio management, it is therefore not necessary to hold concentrated amounts of a few stocks in an attempt to pick the best performers. There is much more risk and a low chance of actually picking the right stocks.

Imagine a portfolio that holds a broad well-diversified portfolio through a specific number of ETFs, where the total number of different stocks is 200. If one of the companies where to even go completely bankrupt, the total loss for the portfolio would not be more than 0.5%. On the other hand, if a portfolio constructed with only 10 stocks were to see one of its investments fail, it would equal a loss to the portfolio of 10%.

Most actively managed Mutual Funds are not allowed to have high concentrations of any particular stock, but picking the wrong stock can have severely adverse effects on the overall performance of the portfolio. The fact that they hold a selection rather than the broader market makes these funds vulnerable to selection risk.

ACTIVE V/S PASSIVE INVESTMENT PERFORMANCE COMPARISON

When looking at performance comparison, it has been very hard over the decades to find sustained periods where actively managed funds outperformed its passively managed peers. It is important to understand the concept of sustained positive returns.

Active fund managers that perform well can be found and usually their outperformance occurs during a limited period of time. However, investing in the stock market with index funds involves a long-term investment horizon. Investing should be considered as a marathon rather than a sprint. It is important then to look at long-term results rather than short-term returns of 1 or 2 years.

When comparing performance between passive and active funds the most interesting metric we have is to look at how often active funds performed in comparison to passive funds. If most of the time active funds outperform passive funds it should mean we are going to be better off investing in the former.

Data shows the opposite to be true. The table below shows the percentage of passive and active management funds that outperformed their passive index.

active vs passive investments

The Lowest Cost column represents passive management funds; they are the funds that charge the lowest fees. The Highest Cost column represents actively managed funds as they charge the highest fees.

We can see that over the 10 year period ending December 31, 2014, active funds underperformed compared to passive funds in all categories. In the US Large Value sector, passive funds outperformed their index 66.3% of the time while active funds outperformed only 18.6% of the time. The above table from Morningstar shows how passive funds are more likely to outperform in all categories as compared of active funds.


PERFORMANCE COMPARISON OF ACTIVE & PASSIVE FUNDS IN U.S. LARGE CAPS

Survivorship rates are also much higher for passive funds compared to actively managed funds. The table below shows that at the end of the 10 year period only 50.22% of active funds were still in business, while for passive funds that rate was 64.91%. 

The table also shows that average performance in terms of annualized returns was also higher for passive funds. Annualized performance for passive funds on an asset weighted basis was 0.94% higher over the 10 year period, and passive fund performance also outperformed active fund performance for all other trailing periods measured.

asset management

The table also shows that higher fees do not generate higher returns. Performance by fee quartile was highest for passively managed funds in the 25th percentile; that is to say funds with fees in the lowest quarter.

Although there may be a role for actively managed funds for certain investors, data shows that in the long run, passively managed funds have lower fees, higher survival rates and better chances of outperforming their index.



Author: Gino D'Alessio 





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