When you're looking to invest in shares or bonds, your approach to managing money can be split into two distinct groups, active and passive. Passive investing is more popular among investors, but there are benefits with active investing that may be more suited to some investors. It is essential to understand the difference in building an investment portfolio that truly reflects your own investment goals.
Active investing
As the name suggests, it is a hands-on approach in which specific investments are made with the goal to outperform an investment benchmark or to achieve a particular investment objective and take advantage of short term price fluctuations.
In the personal finance industry, most people don't have enough time to learn about the intricacies of the stock market and key drivers that impact the movement in prices, so they look for someone to oversee their investments such as a portfolio manager/active fund manager. They seek to beat the market by using their expertise and knowledge for a deeper analysis of the market.
Benefits:
The opportunity for outperformance - as shares and bonds are hand-picked quickly to take advantage of undervalued market sectors, there is potential to make higher returns than the average returns of the market.
Outcomes - active investing allows money managers to meet the specific needs of their clients, such as providing diversification, retirement income, or a targeted investment return. For instance, a hedge fund manager might use an active long/short strategy to deliver an absolute return that does not compare to a benchmark or other measure.
Risks:
Fees and other expenses - Fees are higher with active investing mainly due to transaction costs from the number of buys and sell's made, management, performance, and administration fees. All those related investing fees may have a material impact on your returns over the years and need to be taken into consideration when looking at your return compared to passive investing.
No guarantees on picking a winner - if you are using a professional portfolio manager, you are placing your trust in them. You have to accept there is the possibility that they could misjudge the market and choose underperforming stocks.
Important to note: To do your due diligence on choosing a fund manager, you may decide to speak with a financial adviser for guidance on your investment choices. Ensure that they are independent as many financial advisors are aligned with institutions and may not have your best interests as the priority.
Passive investment
Passive investing is seen as a low cost and low maintenance way to invest and this strategy suits investors who would rather take more of a 'buy and hold' approach. Passively managed funds are often invested in an index fund (e.g., S&P 500 or Dow Jones). A fund will always deliver returns in line with the overall market or sector performance by tracking an index. However, this approach is still not without risks, but successful passive investors mentality is for returns over the long term and will ignore short-term declines in portfolio value.
What is an index?
An index is a collection of shares or bonds chosen to represent a particular part of the market. Passive investors use indexes to track market performance. You can do this either via a Tracker Fund or via an Exchange Traded Fund (ETF). A change in the price of an index should produce an almost identical change in the price of funds that tracks it. (Related articles: What is an ETF? Exchange-traded funds explained, How to invest in ETFs?)
Benefits:
Diversification - maintaining a well-diversified portfolio is an essential part of a successful investment plan, and indexing can be an ideal way to achieve this. For example, if you have funds invested in the S&P 500, this represents the US 500 biggest companies, which means that your investment has a wider spread over the range of products and industries.
Ultra-low fees - as index funds track a target benchmark or index rather than focusing on looking for winners, you can avoid continually buying and selling shares or bonds and will have less oversight from fund managers. As a result, they have extremely low expense ratios compared to actively-managed funds. Many index fund trackers have expense ratios below 0.20%, and ETFs can have expense ratios even lower, such as 0.10% or lower, whereas actively-managed funds often have expense ratios above 1.00%. Therefore, passive investing can have a 1.00% or higher advantage over actively-managed mutual funds before the investing period begins. In summary, lower expenses often translate to higher returns over time.
Simplicity - an index fund offers an easy way to invest in a chosen market as it merely seeks to track an index. There is no need to select and monitor individual managers or choose between investment firms.
Transparency - different from mutual funds which post their holdings monthly or quarterly, you can check ETF holdings whenever you would like because they usually track very transparent industries such as S&P 500 indices in the US and finding the makeup of this index is easily available online.
Risks:
Performance constraints - Index funds are designed to provide returns that closely track their benchmark index, rather than seek outperformance. They rarely beat the return on the index.
Total market risk - Passive funds are limited to a specific index or set pool of investments when the overall stock market falls, so do index funds.
Lack of flexibility - Passive investing is essentially limited to index funds. Index fund managers are usually prohibited from using defensive measures such as moving out of stocks, even if the manager thinks share prices are going to decline.
So, which approach is best?
Both are great strategies, but your personality and time commitments will shape which approach is best suited for you. As a starting point, take a short quiz to see what type of investor you are.
When the markets are on the rise, most index equity funds outperform most active fund strategies, which has helped lead to their increased popularity of passive investing.
Many investment advisors believe the best method is a blend of active and passive styles. To begin, start with an index fund (tracker or ETF) which can be the building blocks of your portfolio and provide your portfolio with diversification. Then, add an actively managed mutual fund and, as part of your research, look for a fund with an expense ratio below 1% and a smaller market capitalisation. Once a fund's market capitalisation gets too big, it becomes hard for the fund manager to duplicate past returns.
Key takeaways:
Information provided by goBuoyant is general in nature and does not take into consideration your personal financial situation. It is for educational purposes only and does not constitute formal financial advice. Remember, the value of any investment can go down as well as up.
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