The active versus passive debate has played out across numerous investment circuits globally, and whilst proponents for each strategy have strong arguments for either approach – the debate still rages on.
To a certain extent, the active vs. passive debate has been mischaracterised and overblown, with both strategies alternating places to come on top of each other every year, depending on market conditions and past results which could sway to either side of the argument.
This article will examine both strategies and why the two do not have to be necessarily be at odds to complement your portfolio.
Active Strategies: Adding Alpha
Active strategies employ a hands-on approach to investing, usually in the form of a portfolio manager who uses tactical decision-making to select securities that has further upside potential.
The overall aim of the portfolio manager is to then maximise returns with the aim to outperform the benchmark index or beat the stock market’s average return.
It involves a deeper analysis and looks at a combination of both quantitative and qualitative factors, to determine the best asset-allocation. The strategy is also premised upon the assumption that active managers are able to take advantage of price differentials in less effcient markets and identify mispriced securities and bargain-hunt.
In emerging markets such as Malaysia, active managers like ourselves are still able to deliver alpha and add returns to outperform the KLCI Index. In contrast, active managers in developed markets like US and Europe are struggling to outperform the benchmark index.
Passive Strategies: Low-Cost, Broad Exposure
On the other hand, passive strategies rely on the effcient market hypothesis which states that markets are effcient and that prices of securities will always factor-in or discount all publically available information. As such, securities will always trade at their fair value, making it diffcult for active managers to consistently pick undervalued stocks and sell them at higher prices.
So instead of attempting to ‘beat the market’, passive strategies like ETFs or index funds seek to mimic the performance of the benchmark or index, so your portfolio’s performance will match the overall returns from the market.
From an investor perspective, this means your returns will only be as good as how the market performs overall, no better or worse-off.
Because, passive solutions like ETF or index funds seek to track the performance of the benchmark index – rebalancing of assets in the funds only takes place when there is a change in constituents or securities in the underlying index. Thus, operational expenses are kept low and as such passive funds charge lower fees.
So Which One Works Better?
Broadly, active investment strategies offer the following distinct advantages:-
- Flexibility – Investors have greater flexibility in their investment approach, since they are not required to follow a specific index. Thus, they have greater ability to tweak their investments according to the desired level of risk, leverage or returns.
- Control – In the same vein, because active strategies do not track an index, investors also have greater control over their investments and can hold securities in different weightage from the index. Perhaps choosing to be overweight on more attractive sectors, underweight on the rest, or even select securities that are not in the index.
- Tax management – Investors could tailor their investing strategies according to the most effcient tax manner
- Potential for higher returns – Active investing has the potential to outperform the index and deliver above the average market’s returns
Because they offer greater flexibility and potential to deliver returns above the index – actively managed solutions often come at a higher cost, whether in the form of trading costs or management fees for unit trusts.
Conversely, passive investment strategies would offer these following advantages:-
- Low-cost – Passive solutions like index funds or ETFs will have lower fees since there is no need for detailed analysis and selective stock-picking, as it merely tracks the index.
- Ease of diversification – Similarly, passive investments offer investors a simple method of constructing a diversified portfolio in a cost-effcient manner. For example, by investing in an ETF, investors can gain broad exposure across various markets & sectors, without having to invest in all the stocks of a particular index.
- Long-term – Passive investments are generally held over the long-term before they exhibit material results, and are thus suited for investors with a similar longer-term investment timeframe.
Because of their cost-effective manner, passive strategies will have limitations on their performance returns – where at best the returns from passive funds will equal the market’s average returns, minus the expenses or fees incurred from the fund (however low).
There is also a potential disadvantage for index funds or ETFs to be unduly concentrated in certain sectors, especially during periods of excessive market exuberance that could lead to inflated valuations like the dotcom bubble seen during the late-1990s – thus, resulting in index concentration risks for investors.
Why not both?
Active/passive strategies do not need to be mutually exclusive of each other. The savviest investor would seek to blend both strategies to create a dual-strategy that has the potential to both outperform via active funds, as well as give broad market exposure using low-cost passive funds.
Frontiers in technology, have also resulted in increasingly innovative products and investment- solutions such as smart-beta ETFs and quant funds that utilizes both active and passive investing strategies.
However, irrespective of both approaches, it is important for investors to understand that neither strategies come without risk nor do they guarantee returns.
Thus, instead of deliberating between active or passive - it is more useful for investors to instead consider if they have the right combination of asset-classes (stocks, bonds, etc) which provides them a diversified exposure to different sectors/markets, small-caps or blue chips - whilst ensuring your portfolio is simultaneously aligned with your investment objectives and risk-tolerance.
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