What Is Passive Investing vs. Active Investing?

Key Points

• A hot topic of investing circles is the merits of passive vs. active investing. At Genvest we think there is room for both.
• Passive investing is simply taking an index, for example the S&P 500, and mirroring those returns by owning the exact same percentage of company names that are held in that index. This can be utilized in nearly every liquid market (meaning easily tradable) and is often the case to invest in a passive ETF.
• An active investor is your classic individual stock-picker who is trying to beat that index. This is tough but can be very rewarding if they select a few names that really take off over the long-term.
• For investors with time and resources to select stocks, active investing can provide superior returns but requires a bit higher risk tolerance. However passive investing is a cheap and easy way to get into the market. There is room for both in investor portfolios depending on the situation.

The Case For Passive and Why It’s A Good Place to Start

Those who argue for passive investing will claim that markets are efficient and difficult to beat. They have a strong case, especially in developed markets and when it comes to investing in large companies(large caps). These names tend to be covered well by Wall Street and regularly invested in, making outperformance more difficult.

The lack of turnover will allow for compounding returns to take effect and the process is simple to understand as the selected fund will just mirror the index. The most attractive feature of passive investing is the lower fees compared to an actively managed investment fund. Fees have been low and continue to come down.

The Case for Active as An Investor Becomes More Experienced

Active investors have the mindset that they will be able to beat index returns through superior stock picking. This is a tough sell in an efficient market(well covered, prices are deemed to accurately reflect asset value) such as U.S. large cap but might hold more weight among small-cap or mid-cap companies, international and emerging market stocks.

The excess returns could enhance the portfolio on a risk adjusted basis through the manager simply being better than the market.

When you locate an active fund manager that you are comfortable with, they can be a great addition to the portfolio to increase your returns relative to those just investing in the index fund. It also provides the opportunity to capitalize on a trend and expose inefficiencies.

Likewise, investors themselves in due time as they become more confident might want to begin selecting a few companies they believe could outperform the index over the long-run for their portfolio.

This action should only be taken after thorough due diligence is completed for a company. In other words, know what you own and why you own it.

ETFs can actively be managed despite being more known for being passive. Historically, mutual fund managers are known for being active managers but also have higher fee structures meaning it will cost you more to invest with them because of the overhead cost of managing the fund.

This is why superior returns will be expected.

Conclusion

Typically, Genvest prefers the lower fees of passive investing in certain markets, especially U.S. large cap (the most invested asset class). However the ability to select an active manager in an inefficient market(not as well covered, asset value might not be as transparent) is a huge addition to the portfolio. To justify the fees on an active portfolio, the manager must have a proven process and track record.

We tend to look in small-cap and emerging markets for active management since they are not as well covered requiring deep research, but there are still opportunities to find accredited active managers for U.S. large cap.

The manager may see a strong business outlook and determine the market value is not accurately reflecting the company’s intrinsic value. In some instances, the active manager might even argue the market is not considering Why Investing in Leadership Matters.