The world of investing sometimes seems like an ever-evolving game, with fund managers and “seasoned” investors continuously advocating different strategies to grow their clients’ or their own wealth.

Two prominent approaches to investment management that have long been hotly debated are active vs passive investing. But what do we really mean by these terms, and is one fundamentally better than the other?

In active investing, fund managers or individual investors aim to outperform the overall market by constantly buying and selling individual stocks and/or other assets like bonds, cash and property, based on their own analysis and predictions. They try to identify undervalued assets or time the market to take advantage of particular (often short-term) opportunities.

Active management requires continuous research, monitoring and decision-making, often leading to higher costs. And, of course, the cost of this resource naturally gets passed on to the client in the form of fees.

Passive investing involves a more hands-off approach. Investors and investment managers build a diversified portfolio that replicates a particular index like the S&P 500, the global share market, or a mix of asset indexes combined. The funds invested into are often referred to as index funds or ETFs.

Lower fees

Instead of attempting to beat the market, they seek to reflect its performance. Passive investors follow the theory that over the long term the market goes up, and by holding a broad range of assets they can harness that growth. Rather than relying on the decisions of an individual or team, this style of management lets a set of particular parameters dictate which assets are included and excluded. Passively managed funds are usually more cost-effective to run and invest in as they involve fewer transactions and typically have lower fees.

Let’s explore four key differences between the two approaches:

1. Diversification: Passive funds typically provide broader diversification across an entire market or sector, reducing the risk associated with individual asset selection. That’s not to say that active funds aren’t diversified, but they wouldn’t tend to hold nearly as broad a range, given each asset is individually bought and managed within the fund or portfolio.
2. Fees: Passive funds generally have lower expense ratios compared to active funds, helping investors retain a higher proportion of their net returns. It is important to consider after-fee returns, given active managers will look to compensate for their higher costs with their portfolio returns.
3. Simplicity: Passive investing is more straightforward, eliminating the need for constant monitoring and frequent portfolio adjustments. For Kiwis, there are plenty of options to choose from in terms of low-cost, diversified or index funds. Many KiwiSaver providers also have a suite of investment options to pick and mix from (usually with a $1000 minimum investment to kick things off).
4. Historical performance: SPIVA, the research arm of S&P Global (which runs the Dow Jones indices), has been providing critical insights into active vs index fund performance for years. The bi-annual SPIVA reports have consistently shown a significant majority of active funds fail to beat their relative indexes over extended periods … aka passive management tends to outperform active (almost 85 per cent of the time*), over a full market cycle. There are, of course, exceptions to every rule, but given active management relies on the decisions and actions of individuals, you can never know whether their next move will lead to future success.

Prudent investors

In my humble opinion (and to be fair, it should be taken as just that), the SPIVA data, alongside difference in cost and the dependence of active management on consistently good decisions, speak volumes, providing substantial evidence in favour of passive investing. While active strategies certainly can and do have their moments of success, the consistency, cost efficiency, and long-term performance of passive investments make them an attractive, as well as efficient, option for prudent investors.

As always, it is essential for investors to understand their risk tolerance, investment objectives, and time horizon before making investment decision.

*The SPIVA Institutional Scorecard Year-End 2021 showed underperformance rates of 83 per cent of both large-cap institutional accounts and mutual fund managers compared to the S&P 500 after deducting fees, over the 10-year period ending Dec. 31, 2021. For the full report go to www.spglobal.com/spdji/en/spiva/article/institutional-spiva-scorecard