Passive Investing Vs Active Investing – How do you choose?

  • Akshatha Sajumon
  • 22 Jan
  • 7 minutes

Investment decisions require a lot of research and analysis to ensure that there is the right mix of investments in one’s portfolio. This will ensure the maximization of returns for the investor in the long run. Investors also have to keep in mind that the cost of investment is not too high which may eventually reduce their returns. Investors can choose many investment products based on various parameters like investment budget, returns expectation, risk factors, etc. However, broadly speaking, there are essentially two forms of making investments: active investing and passive investing. 

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Given below is a brief explanation about the two and the pros and cons of each mode of investment.

Active investing

Active investing is essentially when the investor uses an active investment strategy to generate higher returns. There are two ways of active investment strategy 

  • Investment in actively managed funds (like mutual funds) where the fund managers are the decision makers
  • Investment by the investors themselves using thorough market research and analysis.

Active investing is investment in actively managed funds or stocks and securities that aims at providing maximum returns to the investors, i.e., more than the benchmark returns. This is based on using various investment strategies and knowing when to enter and exit the market to achieve maximum returns. The risk factor in active investing is quite high and hence, the investors have to be cautious about their investments. It is usually ideal for investors having a high-risk appetite. Some examples of active funds are actively managed mutual funds,futures & options, equities, etc.   

Passive investing

Passive investing is a relatively hassle-free mode of investing in the stock market. Passive investing is investments in essentially passively managed funds. These funds usually follow an underlying index or asset for their returns. Unlike actively managed funds, there is no pressure for outperforming the market and generating higher returns. The returns through passive investing are a replication of the underlying index or asset or security which the fund tracks for its performance. Some examples of passive investing are ETFs and Index Funds.

What are the points to be considered while choosing active or passive investing?

Investors have to consider a few points that will help them in choosing between active and passive investment strategies. These points explain the nature of these investment strategies and help them in making better investment decisions.

Category of funds you are investing in

The funds that the investors choose for investment are based on their investment strategy. Funds like mutual funds, individual stocks, or equity funds, hedge funds require the active participation of the fund manager or the individual themselves to generate higher returns than the market and maximize investor’s wealth. 

Funds like ETFs, Index funds, Fund of funds are classic examples of passive investing. These funds may not generate returns higher than the market but they are considered safe and stable investments thereby making them a great addition to the investor’s long-term investment portfolio.

Past performance

Past performance is often used as a benchmark by investors while making investment decisions. While this is an important consideration, it is not advisable to base investment decisions solely on the past performance of an investment product. A majority of actively managed large-cap funds have had a tough time in generating returns over 3, 5 and 10 year periods.

Costs involved in investment

The investment budget is one of the major points of considerations that determine the investment strategy. Active investing requires the active participation of fund managers and a team of analysts that use various technical and fundamental analysis tools that help in generating higher returns for the investors. This ultimately leads to an increase in the costs of investment. 

Passive investing on the other hand does not require such heavy influence of the fund managers and an extensive team of analysts for managing the investments. This has a direct influence on the cost of investments and reduces the expense ratio of the funds significantly. For example, Index funds can have an expense ratio in the range of 0.1-0.2% whereas actively managed funds have higher expense ratios in the range of 1.5-2.5%. Hence costs involved in investments are also an important factor to consider.

Control over the investment portfolio

Active investment strategy provides the investors with the benefit of choosing their investments in their portfolio. Investors can select the investments based on careful research and analysis and matching their investment horizon, investment budget risk-return expectations. 

Passive investing does not provide this option to the investors. The portfolio of the passively managed funds is structured based on the index, asset, or security that it tracks. The assets in the portfolio are usually in the same weightage as the index. Hence, there is no scope for customization of the portfolio which can be availed in actively managed funds.

Transparency in investments

Active investing provides the details of all the investments at regular intervals. However, investors may not get the details of the investment portfolio at any point in time. Passive investing on the other hand involves a portfolio of assets that have assets in the same proportion as in the underlying index it tracks. Hence the investors can be aware of their investments and the underlying assets at any point in time. 

Ability to diverse

Diversification is one of the most important tools for investors to maximize their returns and reduce their risks. Investors in active investing strategy can pick and choose their investments across various categories and assets as well as across different sectors or industries. This gives them the advantage of healthy diversification in their portfolio leading to higher returns. The benefit of diversification is not available in the case of passive investing. Investors cannot choose or alter the assets in the underlying index. Hence, diversification in passive investing is limited to the extent of the different assets under an index of the few sectors that are part of the index.

Conclusion – what to choose?

As discussed above, both actively investing and passive investing have their advantages and disadvantages. Therefore, there is virtually no concept of an ideal investing strategy. This is because what may be a better investment strategy for one investor may not be for another. Hence, the most appropriate scenario may be a mix of actively managed funds and passively managed funds in one’s investment portfolio to generate maximum returns and also a cost-effective investment. 

FAQs

1. What is a more transparent form of investing among actively managed funds and passively managed funds?
A. Securities in passively managed funds are in the same weightage as that of their underlying index. Whereas, actively managed funds are curated based on the assessment and expertise of the professional fund managers. Also, the portfolio information in passively managed funds is disclosed more frequently as compared to actively managed funds. Hence, passively managed funds are considered to be more transparent.

2. What is the expense ratio for passively managed funds?
A. The expense ratio for passively managed funds is relatively lower than actively managed funds. They are in the range of 0.1-0.5%.

3. Which funds are more tax efficient?
A. Taxation on funds is dependent on the asset that the fund invests in. So active or a passive mode doesn’t have much impact on the tax front.

4. What is the ideal portfolio of investments for an investor?
A. The most ideal portfolio for an investor is a correct mix of actively managed funds and passively managed funds to maximize the returns at relatively lower risk and expenses. This depends a lot on the investor preferences and the horizon of investments.

 

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Akshatha Sajumon