top of page

Active vs Passive Investment (Updated)

Updated: Jul 26, 2023




There has been a heated debate between active and passive investing. Whenever such a debate arises, it often gets ugly as each side of the divide wish to prove one strategy is better than the other. It is therefore critical to lay a clear distinction between these investment strategies. Active investing relates to a hands-on approach. As such, it is a strategy that necessitates someone knowledgeable, to be actively involved, and often, the role is played by a portfolio manager. The major aim of employing this strategy is to actively manage the funds so that one can beat the average returns of the stock market and at the same time, take advantage of the price fluctuations in the short term. This kind of investment approach requires greater expertise as well as deeper analysis of the market so that one can have in-depth knowledge of when to get into or out of the market mainly involving the instruments such as bonds, stocks, or any other asset.

A team of experts is therefore employed to analyze all the quantitative and qualitative factors. This enables the team to be able to determine when or where price changes will take place and then make their move. Confidence is essential when employing an active investment strategy and at the same time, knowledge of when it’s the right time to sell or buy (Sushko & Turner, 2018). Passive investing on the other hand relates to an investment strategy in which the investors tend to limit the funds that are used in the purchase or sale within their portfolios. This is viewed as a very cost-effective approach to investing. To achieve this, the investor should employ the buy-and-hold mentality. Generally, one is investing for the long haul.

There is no anticipation or reaction to the stock market changes at every turn. In most cases, this approach mainly involves the purchase of index funds or mutual funds. Although the two approaches are deemed to be effective, passive investing has gained popularity in the recent past and numerous investors have achieved higher investment flows compared to active investments. Passive investing is highly preferable, especially in cases of market disruptions (Kahn, 2018). This paper, therefore, aims at reviewing the debate that is existing between active and passive investing, the reasons that have led to the adoption of passive investing as well as the role of smart beta in modern investing strategies.

Benefits and drawbacks of active and passive investing

Passive investing has become popular in the recent past because of its key benefits which include low fees, decreased risk, enhanced transparency as well as tax efficiency. However, despite the various benefits, there are also drawbacks to this approach. The various drawbacks include funds being limited to a specific set of investments that are predetermined; the returns being regarded as low, there being no known effective exit strategy, especially in stark bear markets and it is regarded as not a flashy option (Sushko & Turner, 2018). On the other hand, active investing which has been employed traditionally has the advantages of flexibility, especially in volatile markets, the possibility of hedging through the use of techniques such as put options or short sales; there are trading options that are highly expanded and active tax management. However, the major drawbacks of this approach include high active risks, trend exposure, being very expensive due to high fees, and at the same time, requiring careful consideration by an expert before making any strategic move (Sushko & Turner, 2018).

Debate on passive and active investment

In the US, the first index tracking funds came into place in the 1970s. Since then, the debate on the superiority of either active or passive investing has been ranging on. However, as demonstrated in the introduction, there is a clear distinction between the two approaches, each bearing its benefits and drawbacks. Today, there has been a drastic shift from the traditional approach of active investing to passive investing. The shift was occasioned by the release of body evidence that demonstrated that the traditional method which was employed in actively selecting the stocks as well as being cognizant of the time markets was highly ineffective.

The evidence also proved that the majority of the fund managers underperformed in their respective jurisdictions and the investors got low returns and were exposed to numerous risks of funds loss. The underperformance by these active managers was attributed to the fact that the market prices are generally fair and as such, it is not possible for the managers to either overprice or underprice the securities (Anadu et al., 2020). These failures led to the emergence of passive investing which has gained popularity among investors due to the numerous benefits that accrue to the approach. However, there is also a common trend of trying to blend the two approaches and attempting to get the benefits of both approaches.

SPIVA

One influential study that sheds light on the active versus passive investing debate is the "S&P Indices Versus Active" (SPIVA) report, produced by S&P Dow Jones Indices. The SPIVA report regularly compares the performance of actively managed investment funds to their respective benchmark indices. It analyzes data over various time horizons, assessing whether active funds outperform or underperform their benchmarks. The results of the SPIVA report provide valuable insights into the effectiveness of active management strategies and help investors make more informed decisions about their investment choices.

Factors contributing to the rise of passive investing

The rise of passive investing has been due to various factors. These factors include; one, low costs. Passive investors have always been on the lookout for a long-term investment option that requires minimal maintenance. Traditionally, the investors had the burden of paying management fees which were paid to the fund managers but in the case of passive investing, there is no payment of such funds. If there are fees to be paid to investment agencies, the fees are always low. Additionally, all the passive funds are included in one investment. This enables automation of the investment hence leading to low fees. The second factor is tax efficiency. This is achieved because the investors do not frequently sell or buy their stock hence reducing the capital gains bills. The bills only accrue when there is a sale or purchase or when an investor exits a position. This helps in reducing the total taxes payable by the investor (Anadu et al., 2020). The third benefit is enhanced transparency. This is due to the fact that the investors are constantly tracking their indexes and as such, they can identify the respective assets that are in a particular index fund.

How alpha and beta been traditionally defined in investment and what the rise and proliferation of smart beta mean for traditional passive investing

Beta and alpha are general measures that are used in explaining the performance of investment funds and stocks. Beta generally measures the extent of volatility concerning an already defined benchmark. On the other hand, alpha relates to the surplus returns that an investment gets after taking into consideration the adjustments for market-related volatility as well as random fluctuations. The two measures are crucial components in predicting and comparing returns. The relationship between the two measures is explained in the equation y= a+ b(x) + u. In this case, the fund or stock performance is represented by y while beta and alpha are represented by b and a respectively, u relates to the residual.

In this case, beta ordinarily helps in determining the systematic that a portfolio or security is exposed to in comparison to a pre-determined benchmark. Generally, the majority of the growth stocks have a beta that is higher than one while the T-bills have a beta that is near zero (Agarwal et al.,2018). Beta is also critical in the measurement of risks that are not diversifiable and as such, helps an investor to determine the portfolio whose risk is within the acceptable level. Market outperformance sometimes arises when there is a low or high beta within a given period.

Alpha on the other hand denotes one of the indicators of risk management mainly for stocks, mutual funds as well as bonds. Through the alpha, the investors can be able to analyze whether the assets they are interested in have performed poorly or better than what is predicted by the beta. When the alpha is negative, it is an indication of higher risk. When it is zero, it is an indication of fair return which is equivalent to the risk it was exposed to while an alpha of more than one indicates that the investment had a better performance in comparison to the risk that was prevailing. Traditionally, the fund managers used to indicate an alpha of more than one which was an indication that they can outperform the market, or generally, they are in a position of manipulating the market to their advantage (Agarwal et al.,2018). However, this position has been overruled by evidence that the market price is generally fair and as such, manipulation of the price is not possible.

The beta, as well as alpha factors, has always been a grave issue when trying to differentiate between active and passive investing. Fund managers have always asserted that it is possible to determine the true alpha and at the same time determine the beta for their investments through active investing. However, studies have shown that it is not possible to determine the true alpha and its determination would require a long duration mainly over a decade to be certain. It is therefore imperative to note that the two factors are risk ratios and as such, they are crucial components in the determination of market returns. Although it is not possible to predict these factors, one should know how to calculate them and the effect they have on one's choices. Today, the majority of investors have found smart beta strategies to be highly attractive (Densmore, 2022). This has been occasioned by the fact that there is a need for diversification of investment strategies, higher returns, low risks, and lower costs. All these factors are achieved through the employment of smart beta strategies.

Conclusion

The debate between active and passive investing has been ranging on and will continue in the foreseeable future. However, due to the market dynamics and the risks that active investing exposes investors to passive investing has gained popularity. However, investors need to have a good understanding of the beta and alpha factors, which are critical in the determination of investment risks. Today, the majority of investors have appreciated the role that the two factors play in the investment field and have endeavored to explore studies that will enable them to gain a better understanding of the role of these factors before making their investment decisions. The advent of smart beta strategies and the insights provided by the SPIVA report have revolutionized the investment field, offering investors diverse options and the potential for superior performance, while also managing risks and expenses more effectively. As investors explore these strategies, the future of investment decisions is likely to be shaped by their adoption and further research in this area.

27 views0 comments

Comments


bottom of page