ACTIVE & PASSIVE INVESTING: 5 THINGS YOU NEED TO KNOW
All good investment portfolios need smart strategy. One of the key challenges people face when choosing investment funds is whether to go for an active or passive investment strategy.
We break down what you need to know about the differences between active vs passive investing so you can decide what works best for you.
01 HOW THEY WORK
Active investments, or actively managed funds, work by trying to outperform the market index. A human asset manager is employed to avoid the market bumps.
Passive investments, or index tracking funds, track the market index. Your investment passively rides the bumps of the stock market, seeing the same gains and losses as the index.
NOTE:
The market index follows the ups and downs of the stock exchange. For example, the S&P ASX200 is a market index that tracks the top 200 biggest Australian publicly traded companies.
You can read about the differences between managed funds vs ETFs in this article.
02 WHAT THEY COST
Active investment funds have higher operating costs than passive investment strategies.
Passive investment strategies have lower turnover and trading costs and are also more tax efficient.
NOTE:
You can compare these examples of a Vanguard active investment fund vs. a Vanguard passive investment fund.
03
WHAT ARE THE RISKS
The risks of an active investment fund are higher than a passive fund following the market index. Higher risk can mean higher returns but also larger losses if the asset manager doesn't beat the market index.
Passive investment funds are generally lower risk because they are pretty much guaranteed to match the market index. Lower risk can mean lower returns than you might see with an actively managed fund.
NOTE:
Some investors think that tracking the market index isn't an effective investment strategy because the market is inefficient.
Investing in an active fund might see quicker returns but, then again, the market isn't always easy to beat so you might see more losses than gains in the long term. You can read more about the arguments for and against passive investment funds here.
04 short or long term?
An active investment strategy involves a lot of buying and selling because the asset manager is trying to out-perform the market index. This makes it a better short term strategy because you can take advantage of short term price fluctuations.
A passive investment ignores the short term fluctuations but the strategy has a long term focus on the market trajectory. There is less buying and selling shares than you see with an active fund but because you are tracking the market index the shares within this index might change. For example, a market index following the 200 biggest Australian companies (like the S&P ASX200) might change depending on which companies perform better than others.
05 WHICH IS EASIER?
Active funds cost more for a reason. They require a lot more human expertise and active assessment. Asset managers need skills to identify opportunities and assess the risks. You need to know what to look for when choosing an asset manager, just like you would in hiring someone for any job. Choosing a good asset manager makes the process more complex for everyday investors.
Passive funds are simpler both for everyday people investing as well as the fund manager. There is less research, analysis and decision-making involved in a passive fund than an active one. The fact that they are simpler to understand than other investment strategies makes passive funds an attractive option for investors.
You don't have to choose one over the other either. Depending on your situation, it can be beneficial to have a healthy mixture of both active and passive strategies in your investment portfolio.