Benefits and Drawbacks of Passive Investing vs Active Investing

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There is often a debate within financial circles as to whether the best mode for investing is based on a passive approach or an active approach. There are adamant supporters for each style of trading. In this lesson, we will clearly define the difference between active and passive investing. Additionally, you’ll learn the benefits and drawbacks of each style.

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Passive Investment Strategy

Passive investing is a form of investing that focuses on a more long-term approach to the markets. Passive investors take a much less active role in the day-to-day management of their portfolio. Instead they focus on buying stocks, bonds or other holdings for the long term, and typically allocate a sizable portion of their portfolio to index funds. Passive investors need to be very patient with their portfolio, and refrain from the desire to predict market movements over the short-term.

One of the most popular vehicles for a passive investment strategy is the use of equity index funds. This includes stock index funds that track the S&P 500, the NASDAQ 100, the Dow Jones Industrial Average, and the Russell 2000. Essentially, an equity index fund is comprised of all the stocks within a specified market index. Typically, index funds are weighted by market capitalization, which means that stocks with a higher market cap will make up a larger percentage of the holdings than stocks with smaller market caps. With this type of approach investors are seeking to mimic the performance of the overall index.

Passive investing through index funds can provide for a low cost way to meet your financial objectives. Most passive investors are considered buy-and-hold market participants. They are most concerned with the performance of their portfolio based on a longer-term time horizon as opposed to the daily fluctuations that occur within the stock market. The passive fund investor will often enjoy the benefits of diversification, and be able to protect themselves from a major adverse move resulting in any single stock issue.

Aside from the stock market, passive investors can also engage in the bond, commodities, forex, and futures markets. The idea however, is the same. And that is to say that the passive investor will seek to invest in in a specified fund in an effort to realize gains based on a longer-term trading horizon.

This can be done through managed futures accounts, managed forex accounts, commodity trading advisors, hedge funds, and other similar investment arrangements. It’s also important to note that passive investors do not necessarily need to be fund investors. Although this is the case in most instances, passive investors can be self-directed traders who make their own trading decisions in the market. Regardless, the primary objective of the passive investor is to have a limited amount of interaction in the market or take a completely hands-off approach.

Active Investment Strategy

Active investing is a mode of investing wherein there is a more hands on approach to market related decision-making. Most active investors seek to engage in the market more actively in an effort to make gains that surpass those that can be realized from a more passive approach. Active investors can assign a portfolio manager to manage their funds, or act on their own behalf in the markets as self-directed traders. In either case, the active investment philosophy seeks to outperform the market index in the case of index funds, or to outperform other buy-and-hold investing techniques.

Many active investors study technical and fundamental analysis to gain an edge in the market. Rather than relying solely on capital appreciation for the longer-term, active investors try to extract profits from the market based on their outlook and analysis. Because of this, active investors must have a deeper understanding of the underlying factors that contribute to price movement in the market. And this is so regardless of whether they are trading stocks, commodities, forex, cryptos, or any other asset class.

Active investors are on a constant pursuit of Alpha, which is to say that their higher frequency of trading is aligned with their desire for excess returns beyond corresponding market indexes. Although this is certainly the goal of the active investor, many fall short of achieving it. One of the reasons for this is that a more active trading strategy requires more participation in the market. And that participation comes at a cost.

More specifically the active trader will incur a much higher cost of trading in the combined form of bid ask spreads, slippage, and commission. This friction, as it is often called, can account for a sizable portion of the gross profit that may be realized from trading activities. As such, active traders need to be ever cognizant of these related costs.

It’s also important to realize that an active trading methodology is much more time intensive than a passive strategy. Many traders and investors do not take this into account, but it’s an important consideration, especially for those that may be in professions where there time is highly valued monetarily. Depending on the capital base, and the additional time requirement associated with active trade management, it may prove more worthwhile for some individuals to stick to a more passive investment method.

passive-investingBenefits and Drawbacks of Passive Trading Approach

As you’re now familiar, most passive investing strategies seek to mimic the returns of a specified market index. There are typically no portfolio managers that are making buy, sell, or hold decisions outside of the normal portfolio turnover realized from rebalancing activities associated with the benchmark index.

After taking into account expense ratios and other related costs, passive investors will fall short of the returns realized from the market index that is being benchmarked. Nevertheless, due to the limited time commitment required of passive investors, it can be a great solution for a certain class of investors. Let’s now take a deeper look into the pros and cons of a passive investment philosophy, particularly via index funds.

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Benefits of passive investing in the market:

Low transaction costs– Most passive funds offer a relatively low fee structure. The primary fee structure comes in the form of an expense ratio, which is a management fee associated with maintaining the portfolio of stocks within the benchmark index. It is calculated as a percentage of your account size. The typical cost of a passive index fund could be as low as .10% to as high as .30% in some cases.

More tax efficient – The gross returns that you generate on your investment is just one part of the equation. It’s important to assess your net realized return after taking into account federal, state and local taxes. A passive investing approach is much more tax efficient, allowing you to keep more of your gross realized profit. This is due to the lower turnover that is inherent in most passive investing programs.

Limited time commitment – There are various considerations that should be accounted for outside of the potential returns from an investment. One in particular that should be factored in is the amount of time required for managing your investment portfolio. Passive investing strategies require very little in the way of your dedicated time. This can prove to be a very efficient way to earn returns from the market.

Limited market knowledge needed – Although you need to understand some basic investment philosophies and jargon associated with the market, your level of knowledge about the financial markets and all the intricacies that go along with it, does not have to be particularly deep in order to benefit from a passive trading strategy. It is a well suited investment strategy for those who do not have the time or the desire to commit to an in-depth study of the markets.

Fully invested portfolio – In active trading strategies the investor or trader is typically only allocating a small portion of their overall account to participate in a particular trade. This can result in a large cash balance which may not be earning sufficient interest or income in its dormant state. The passive investor, on the other hand, has the advantage of being fully invested in most cases through their index fund investment. This can have the benefit of amplifying returns, since most if not all of the capital within the account is being utilized.

Built-in diversification – By its very nature, an index fund consists of a relatively large number of securities. This can provide for a high level of diversification in comparison to nonpassive strategies that often have a more concentrated position on, which can sometimes lead to unbalanced risk exposure.

Drawbacks of passive investing in the market:

Limited downside protection – Most passive investing funds tend to be long only. This includes most equity and commodity funds. As a result, a passive investor will typically only realize profits during bullish trends. They will often lose money during bearish trends. This is how most mutual funds and index funds are set up to operate. The exception to this are inverse ETFs, which benefit from price movements to the downside. These inverse funds, however, have their own set of drawbacks that need to be considered.

Lower potential returns – Whereas active trading styles seek to generate profits in excess of typical benchmark returns, most passive investing strategies are limited to the returns realized from the underlying market index. As a result, the potential for outsized gains is only present when the overall market and economy as a whole is performing spectacularly.

Cookie-cutter funds – The passive investing industry provides a fairly limited number of choices when it comes to unique investment options. Though there may seem to be many different types of index funds that track the market, most are essentially the same. As such, passive investors seeking a more specialized portfolio allocation may find it difficult to fulfill their specific investment objectives.

Not suited for all asset classes – Equity index market funds are best suited for the passive investing approach. Passive investors seeking to participate in potential trends in other asset classes such as gold, silver, energy, agricultural commodities, or other specialized markets may find it difficult to do so.

Although there are plenty of long only asset funds available to the passive investor, these specialized markets are not well suited for long only positions. This is primarily because most markets outside of the equities markets do not have a long-term upward bias. Instead, these asset classes tend to go through boom and bust cycles on a regular basis. This requires a more active trading approach that combines market timing with the ability to trade both to the long side and to the short side.

Benefits and Drawbacks of Active Trading Approach

Let’s now turn our attention to the discussion of the active trading investment philosophy. As we noted earlier, an active trader seeks to engage in the markets on a more regular basis in an attempt to make better gains than can be typically achieved through a passive investing style.

Active traders have several different options for achieving their goals. And they can buy into a fund that is actively managed by a portfolio manager and his or her team, or they can opt to actively manage their own portfolio or trading accounts. The decision of which medium to choose will come down to each traders personal preferences and their inherent strength and weaknesses. Regardless, there are a few key advantages and disadvantages that should be considered when taking on an a more active investment management role.

Benefits of active trading approach in the market:

Ability to hedge – Many active trading programs have the flexibility of taking on positions both to the long side and to the short side. As a result, active investors have a better ability to profit from both uptrends and downtrends. In addition, they are able to hedge their portfolio much more efficiently due to this ability to trade on both sides of the market.

More choices available – Unlike the passive investor who has a limited number of choices, active investors are able to pursue many more opportunities within the market. This can include long short equity trading, futures trading, foreign exchange trading, options trading, and more. Active traders have the ability to find hidden gems through their research efforts. This can include both fund selection and individual security selection.

Opportunity for better returns – Active traders are in search of above average market returns. Depending on their level of success, they can often be rewarded with returns that exceed those of the market averages. Although this is not always guaranteed, the active trader nevertheless has the ability to apply their skill set in order to beat the typical buy-and-hold strategy.

Can be custom tailored – As we mentioned earlier, passive index funds are essentially the primary product tailored for passive investors. Active investors can trade a countless number of products, and find opportunities to invest in areas that may be more specialized and tailored to their specific wants and needs. This could be in the form of a sector rotation strategy, futures trend following strategy, a reversion to the mean option strategy, or a volatility breakout forex strategy, to name just a few.

Drawbacks of active trading approach in the market

Higher transaction costs – For the privilege of transacting more frequently in the market, the active trader must incur higher costs associated with that activity. This can have the effect of lowering the realized profit after deducting bid ask spreads, slippage, commissions, and other related transaction costs. The active trader must be careful and ensure that they are only entering into positions that have a positive expectancy after these costs have been factored in.

In-depth market knowledge required – Many active traders are extremely passionate about the markets. And this is one of the reasons that they may have chosen to take a more active role in the investment process. That passion helps to fuel the requirement of needing to have a solid understanding of price action and market movements as a whole. For those active traders who lack this desire for market knowledge, they may be at a disadvantage to their peers. Additionally active trading requires a disciplined trade selection and management process that needs to be continually honed for best results.

Less tax efficient – In most cases, active trading strategies will incur much higher turnover than passive investing approaches. As such there will often be tax implications in the form of higher capital gains. This is a big disadvantage that can prove quite costly for many active traders.

As a result, it’s important that you compare your net returns after tax for your active trading strategy, rather than focusing too much on your gross returns. In certain cases, you may find that even though your active trading strategies are resulting in better performance figures, the net result after taxes doesn’t leave you in a much better position than what a passive investment approach would have netted you.

Can be more risky – Generally speaking, active investment strategies tend to take on more risk than passive investment strategies. One reason for this is that the active investor or trader is often looking for that needle in the haystack that is going to provide outsized gains.

This can lead to overexposure on a particular position or sector. Often when the active trader is correct in their analysis, this type of concentrated trading can lead to a windfall of profits. However, the flipside of that is that in case the active trader’s analysis proves incorrect, it can also lead to excessive losses.

Combining Active and Passive Investment Strategies 

We detailed the difference between active versus passive investment strategies. Additionally we looked at the pros and cons of both passive investing as well as active trading. Now although we presented the two different investment techniques on their own, they are not necessarily mutually exclusive.

More specifically, an investor can choose to incorporate both types of strategies within their portfolio. This would create a more hybrid investing style that could add further diversification to a portfolio and possibly provide for a smoother equity curve.

We know that in certain market environments passive investing will tend to outperform active investing techniques. And similarly, at other times active investing will tend to outperform passive investing strategies. Although this is a broad generalization, there will inevitably be times within the market cycle that one style will outperform the other.

It is however difficult to know ahead of time when one has some advantage over the other. As a result, it can make sense to allocate a certain percentage of your portfolio to passive investing methods, and allocate another portion to your active trading efforts. This can have the effect of generating a better risk-adjusted return.

Barron’s cited an in-depth study that compared the performance returns of three different groups of investment models. One that was based on an all active investment approach,  another that was based on an all passive investment approach, and a third which was based on a hybrid model which included both passive and active strategies.

What the study found based on 20 years of data was that portfolios that were based on a combined active and passive investing style outperformed the all passive and the all active management techniques. And more specifically, the combined approach provided for a boost in overall performance by approximately 25%. This data certainly provides a case for a hybrid investing model.

Download the short printable PDF version summarizing the key points of this lesson….Click Here to Download

Final Thoughts

We’ve presented a fairly in-depth comparison of a passive versus active management strategy. Although the debate will continue long into the future, it is my belief that there is no absolute correct answer that can be applied as a broad stroke.

Each individual investor will have different investment goals, experience level in the market, professional background, and personal interests. Because of these varied factors, the choice between an active and passive strategy or a hybrid investing style will need to be determined by each individual investor.

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