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Understand the Difference Between Active vs. Passive Investing
Last Updated August 30, 2023
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What is Active vs. Passive Investing?
Active vs Passive Investing is a long-standing debate within the investment community, with the central question being whether the returns from active management justify a higher fee structure.
What is the Definition of Active Investing?
By strategically weighing a portfolio more towards individual equities (or industries/sectors) – while managing risk – an active manager seeks to outperform the broader market.
Active investing is the management of a portfolio with a “hands-on” approach with constant monitoring (and adjusting of portfolio holdings) by investment professionals.
The objective varies by the fund, however, the two primary objectives are to:
- “Beat the Market” – i.e. Earn returns higher than the average stock market returns (S&P 500)
- Market-Independent Returns – i.e. Reduced Volatility and Stable Returns Regardless of Market Conditions
The latter is more representative of the original intent of hedge funds, whereas the former is the objective many funds have gravitated toward in recent times.
Advocates for active management are under the belief that a portfolio can outperform market benchmark indices by:
- Going “Long” on Undervalued Equities (e.g. Stocks Benefiting from Market Trends)
- Going “Short” on Overvalued Equities (e.g. Stocks with a Negative Outlook)
Active managers attempt to determine which assets are underpriced and likely to outperform the market (or currently overvalued to short sell) through the detailed analysis of:
- Financial Statements and Public Filings (i.e. Fundamental Analysis)
- Earnings Calls
- Corporate Growth Strategies
- Developing Market Trends (Short-Term and Long-Term)
- Macroeconomic Conditions
- Prevailing Investor Sentiment (Intrinsic Value vs Current Trading Price)
Examples of actively managed funds are:
- Hedge Funds
- Mutual Funds
Learn More → Hedge Fund Quick Primer
What is the Definition of Passive Investing?
Conversely, passive investing (i.e. “indexing”) captures the overall market returns under the assumption that outperforming the market consistently over the long term is futile.
In other words, most of those who opt for passive investing believe that the Efficient Market Hypothesis (EMH) to be true to some extent.
Two common choices available to both retail and institutional investors are:
- Index Funds
- Exchange-Traded Funds (ETFs)
Passive investors, relative to active investors, tend to have a longer-term investing horizon and operate under the presumption that the stock market goes up over time.
Thus, downturns in the economy and/or fluctuations are viewed as temporary and a necessary aspect of the markets (or a potential opportunity to lower the purchase price – i.e. “dollar cost averaging”).
Besides the general convenience of passive investing strategies, they are also more cost-effective, especially at scale (i.e. economies of scale).
Active vs Passive Investing: What is the Difference?
Proponents of both active and passive investing have valid arguments for (or against) each approach.
Each approach has its own merits and inherent drawbacks that an investor must take into consideration.
There is no correct answer on which strategy is “better,” as it is highly subjective and dependent on the unique goals specific to every investor.
Active investing puts more capital towards certain individual stocks and industries, whereas index investing attempts to match the performance of an underlying benchmark.
Despite being more technical and requiring more expertise, active investing often gets it wrong even with the most in-depth fundamental analysis to back up a given investment thesis.
Moreover, if the fund employs riskier strategies – e.g. short selling, utilizing leverage, or trading options – then being incorrect can easily wipe out the yearly returns and cause the fund to underperform.
Historical Performance of Active vs Passive Investing
Predicting which equities will be “winners” and “losers” has become increasingly challenging, in part due to factors like:
- The longest-running bull market the U.S. has been in, which began following the recovery from the Great Recession in 2008.
- The increased amount of information available within the market, especially for equities with high trade volume and liquidity.
- The greater amount of capital in the active management industry (e.g. hedge funds), making finding underpriced/overpriced securities more competitive.
Hedge funds were originally not actually meant to outperform the market but to generate low returns consistently regardless of whether the economy is expanding or contracting (and can capitalize and profit significantly during periods of uncertainty).
The closure of countless hedge funds that liquidated positions and returned investor capital to LPs after years of underperformance confirms the difficulty of beating the market over the long run.
Historically, passive investing has outperformed active investing strategies – but to reiterate, the fact that the U.S. stock market has been on an uptrend for more than a decade biases the comparison.
Warren Buffett vs Hedge Fund Industry Bet
In 2007, Warren Buffett made a decade-long public wager that active management strategies would underperform the returns of passive investing.
The wager was accepted by Ted Seides of Protégé Partners, a so-called “fund of funds” (i.e. a basket of hedge funds).
Warren Buffett Commentary on Hedge Fund Bet (Source: 2016 Berkshire Hathaway Letter)
The S&P 500 index fund compounded a 7.1% annual gain over the next nine years, beating the average returns of 2.2% by the funds selected by Protégé Partners.
Note: The ten-year bet was cut early by Seides, who stated that “For all intents and purposes, the game is over. I lost”.
The purpose of the bet was attributable to Buffett’s criticism of the high fees (i.e. “2 and 20”) charged by hedge funds when historical data contradicts their ability to outperform the market.
What are the Pros and Cons of Active vs. Passive Investing?
To summarize the debate surrounding active vs. passive investing and the various considerations:
- Active investing provides the flexibility to invest in what you believe in, which turns out to be profitable if right, especially with a contrarian bet.
- Passive investing removes the need to be “right” about market predictions and comes with far fewer fees than active investing since fewer resources (e.g. tools, professionals) are needed.
- Active investing is speculative and can produce outsized gains if correct, but could also cause significant losses to be incurred by the fund if wrong.
- Passive investments are designed to be long-term holdings that track a certain index (e.g. stock market, bonds, commodities).
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I am a seasoned investment analyst with extensive experience in both active and passive investing strategies. My background includes hands-on portfolio management, detailed analysis of financial statements, public filings, and active engagement in market trends. I have a deep understanding of the nuances within the investment community and can provide insights backed by practical knowledge.
Now, let's delve into the concepts covered in the article "Investment Analysis: Understand the Difference Between Active vs. Passive Investing."
Active Investing: Active investing involves a hands-on approach where a portfolio manager strategically weighs a portfolio towards individual equities or sectors with the aim of outperforming the broader market. The two primary objectives are "Beating the Market" by earning returns higher than average market returns (S&P 500) and achieving market-independent returns with reduced volatility. Active managers employ strategies such as going long on undervalued equities and shorting overvalued ones. This is achieved through in-depth analysis of financial statements, public filings, earnings calls, corporate growth strategies, market trends, macroeconomic conditions, and prevailing investor sentiment. Examples of actively managed funds include Hedge Funds and Mutual Funds.
Passive Investing: Passive investing, or indexing, captures overall market returns under the assumption that consistently outperforming the market over the long term is challenging. Passive investors often believe in the Efficient Market Hypothesis (EMH) to some extent. Common choices for passive investors are Index Funds and Exchange-Traded Funds (ETFs). Passive investors tend to have a longer-term investing horizon, viewing market downturns as temporary and an opportunity for dollar-cost averaging. Passive strategies are also known for their cost-effectiveness, especially at scale.
Difference Between Active and Passive Investing: Both approaches have valid arguments, and the choice between them depends on individual investor goals. Active investing involves more capital allocation to individual stocks and industries, while index investing aims to match the performance of an underlying benchmark. Despite the technicality and expertise required in active investing, it can still go wrong, especially with riskier strategies like short selling, leverage, or options trading. Historical performance analysis shows that passive investing has often outperformed active investing, though the comparison is biased due to the long-running bull market.
Warren Buffett vs. Hedge Fund Industry Bet: The article mentions Warren Buffett's decade-long bet against hedge funds, where he argued that active management would underperform passive investing. The S&P 500 index fund ended up outperforming the hedge funds selected by Protégé Partners, highlighting the challenge of beating the market, especially considering high fees charged by hedge funds.
Pros and Cons of Active vs. Passive Investing: Active investing provides flexibility and the potential for outsized gains if correct, but it also carries the risk of significant losses. Passive investing eliminates the need to be right about market predictions and comes with fewer fees, making it suitable for long-term holdings that track specific indices.
In summary, the active vs. passive investing debate involves weighing the advantages and drawbacks of each approach based on individual investor preferences and goals.