Investment Strategy – Active vs Passive Investing

Though a profit-seeking motive is common to all investors, individual or corporate style of investing often differ due to influence by factors ranging from age/life cycle (young, middle life, or nearing retirement), business cycle, risk appetite, cash flow requirement (daily needs, medicals, and funds for children’s education) and investment goals.

The two major styles of investing made up of active and passive investing, have over the years generated robust debates amongst its adherents promoting one at the expense of the other. We are of the opinion that these styles of investing are not mutually exclusive. The objective of this piece is, therefore, to highlight their principal features, benefits, and differences to enable investors gain a better understanding of how they work and apply them to enhance their investment decisions.

Passive Investing

Passive investing involves buying and holding securities with a long-term horizon without actively trying to profit from short-term price fluctuations in the market. It requires good high-quality initial research, patience, and a well-diversified portfolio. Proponents of passive investing are regarded as true investors in the market. They believe it is not possible to accurately identify investments that will consistently top market averages at a low enough cost to justify the effort; they rely on the belief that in the long term the investment will be profitable.

Passive investing is about reaching your goal by creating the right portfolio allocation, applying it to any asset class from the start, and not speculating on the future of the markets by trying to predict trades. Passive investing offers investors the highest probability of reaching their financial goal and as it simply duplicates their respective investable universes. They prefer to own all the stocks, because they think as a whole, over long periods of time, efficient market forces will work and they are likely to receive higher returns from investing in the entire stock market than by trying to pick the individual stocks which will outperform the market as a whole.

Features of Passive Investing

Passive investing is based on the assumption that market forces are efficient; it has the following key features:

Long Term Investment Horizon

Although the time frame of many passive investors differs, passive investing can be defined as investing with the expectation of buying and holding an asset, security, portfolio, or investment strategy for an indefinite period of time by an investor with the capability to do so. Typically this long-term investment is expected to be held for at least 10 years or through an entire business cycle.

Passive investors are principally value makers, not price takers whose responsibility is to add value to the social and environmental, as well as the financial, value of their investments. This is because the wealth companies create is more than the stock price.

Buy and Hold

Buy and hold investing was made popular by Warren Buffet. It is an investment strategy where investors seek to purchase and hold assets of companies that an investor can feel comfortable about holding over the long run.

One of the soundest reasons for subscribing to the buy and hold investing philosophy or strategy is what is known in the world of investing as the “Efficient Market Hypothesis”, or EMH. The Efficient Market Hypothesis puts forth the idea that stock markets are “information efficient,” which is to say that an investor cannot realize consistent returns in excess of the average returns of the market on a risk-adjusted basis, based on the available information at the time the investment is completed.

Other advocates of buy and hold investing believe that it is a sensible cost-based system as brokerage costs and other fees are incurred on every stock trading transaction, and buy and hold investing is a strategy that involves the fewest number of transactions for a given amount invested in the market if all other aspects of the investment are equal.

Index Funds

An index fund is a form of passive investing that is made up of a collective investment scheme (usually a mutual fund, or exchange-traded fund) that aims to replicate the movements of an index of a specific financial market (i.e. Nigerian Stock Exchange’s ASI, New York Stock Exchange’s S&P 500), or a set of rules of ownership that are held constant, regardless of market conditions.

An index tracker is designed to beat market returns by holding all of the securities in the index, in the same proportions as the index. Other methods include statistically sampling the market and holding “representative” securities.

Among its prominent features, an index fund is said to provide broad market exposure as it covers a comprehensive segment of the market, is simple and easier for investors to understand, low operating expenses due to less transaction cost and cost of sales, delayed tax payment on capital gains realized from sales of stock removed from the index and low portfolio turnover due to less frequent contact with brokers with investment portfolio fund managers without stock options or the identification of market timing.

Index fund investing also offers some measure of protection against investment risks due to broad diversification. Any individual stock volatility index fund will not have the overall performance impact that will spread the risks. Since index funds aim to match market returns, an under or over performance often occurs, this is known as tracking error.

Advantages of Passive Investing

Passive investing presents some cogent advantages which include:

  • Reduced uncertainty of decision errors. There’s less exposure to the risk market as investors are not reaching beyond the risk profile to earn fantastic returns.
  • The cost of transaction, management, and maintenance is lower.
  • It captures the return of an entire market because of its wide coverage.
  • It has style consistency that ensures investors achieve efficient and technical asset allocation.

Disadvantages of Passive Investing

Despite its laudable benefits, passive investing has certain setbacks which include:

  • Cause and effect mismatches: Many investors assume past results are representative of future results, they, therefore, overbuy stocks with impressive earning history, or with high past returns. Past returns do not necessarily mean it will recur in the future.
  • Excessive risk aversion:  Some passive investors become obsessive about short-term price movements in a single stock instead of focusing on changes in their total wealth.
  • Investment restrictions bias:  Many individual or institutional investors are restricted by Memorandum and Articles of Association as well as Funds’ Investment Policy, on the type of securities they are allowed to invest in. Such restrictions decrease market efficiency and leave openings to be exploited by opportunistic fund managers.

Active Investing

Active investing is an investment strategy that aims primarily to “beat the market”, it involves an on-going buying and selling action by an investor or a fund manager(s) within the purview of an investment objective. Active investors are more of speculators who purchase investments and continuously monitor their activity in order to exploit profitable conditions and they typically look at the price movements of their stocks many times a day while seeking short-term profits. Active investing is the art of stock picking and market timing.

It leans heavily on analytical research, forecasts, and subject judgement in making investment decisions on what securities to buy, hold and sell. Active investors do not follow the efficient market hypothesis. They believe it is possible to outperform the market and profit from the stock market through any number of strategies that aim to identify mispriced securities. This style of investing requires substantially more on-going research and discipline (emotional and logical).

Features of Active Investing

Active investing has some definitive features which include:

Stock Picking

Investors or fund managers using this investment strategy often believe they can pick the “right” stocks that are going to outperform the market. They hold the idea that with enough research and the right insights or systematic analysis they can rightly forecast to find values that other people have missed and make a fortune in the process.

Market Timing

Active investors believe strongly they can predict the future direction of the market and time their entry into and exit out of the market while beating market index returns. They believe it is possible to tell when they should sell all their stocks and put everything in cash. Or they think commodities (or any other specific asset class) are overvalued and it is time to start buying foreign stocks (or some other specific asset class). This is often called “Tactical Asset Allocation”, but it’s essentially Market Timing any way you look at it. Active Investors often apply the same line of thinking to individual stocks or bonds. To the active investor, timing is everything and they spend time trying to forecast stock market turns or trend reversal.

Risk Inclined

Active investors and fund managers are by nature risk inclined often committing funds into an investment without weighing the risk of the investment and their own risk tolerance.

Advantages of Active Investing

  • It provides a crucial platform for investors seeking to generate absolute returns on their investment.
  • Its management provides wide varieties of strategies for analysing and identifying mispriced assets in the capital markets (i.e. currencies, bonds, stocks, commodities, etc.) thereby building asset portfolios that will benefit most when the market corrects for these mispriced assets, to eventually deliver good returns on investment.
  • It provides proactive management with a potential advantage for equity and other investment vehicles in the short/long run.
  • It provides flexible portfolio management that has several advantages in the period of negative returns or increased volatility in the market. The ability to shift exposure and change from aggressive to defensive stocks allows fund investors to capture the upside of an upward-trending market while protecting capital in down periods.

Disadvantages of Active Investing

  • Exorbitant transaction fees. The cost of buying and selling regularly as well as meeting research and overhead cost often whittles down the gains of the investment. Also, capital gains resulting from frequent trade often have unfavourable income tax impact when such funds are held in a taxable account.
  • When the asset base of an actively-managed fund becomes too large, it begins to take on index-like characteristics because it must invest in an increasingly diverse set of investments instead of those limited to the fund manager’s best ideas.
  • Manager risk increases inherent market risk. The probability of making an investment mistake is increased as the manager seeks to beat the market index return.

Despite the considerable amount of debate among proponents of active and passive investing, the fact remains that both styles of investing complement each other and an unbiased investment adviser that correctly identifies the advantages and disadvantages of both strategies can help clients create investment portfolios that allow the benefit of both worlds.