Active vs Passive: Which one are you better off doing?

Active vs passive investing are the two most common investment strategies. The clearest difference between them is that active investing tries to outperform an index over time whilst passive matches it. For example, active investing looks to better indexes like the SP500, when passive would just be the same as investing solely in the SP500. Both strategies have their advantages and disadvantages – it will come down to personal preference, trading style and time horizon.

Active funds  

Active funds intend to outperform a specific index, called a benchmark. Here you’ll see many investors put their portfolio performance against a specific index. Most of the time, it is the SP500. There are many traders on eToro, who are active investors. They are looking for a portfolio of single stock holdings that they hope to beat the index benchmark. In the real world, active investors are like hedge fund/portfolio managers. So, you’ll need to consider their fees, which usually have higher fees than passive funds.

Pros and cons of active vs passive investing

Active funds are run by humans and are susceptible to human emotions and errors that come with trading. They need to constantly analyse individual stocks to ensure that they will outperform the index. They can focus on particular sectors like technology or healthcare stocks. Typically, they do this research as part of a team and provide recommendations or buy on your behalf. So, a benefit of this is that you’re essentially giving them your money to let them do all the hard work for you. You can also do this yourself by building a portfolio of individual stocks.

However, you’ll need to do the research yourself. The basic idea behind this is that it allows ordinary investors to hire professional stock pickers to manage their money. When things go well, actively managed funds can deliver performance that beats the market over time, even after their fees are paid.

There’s a caveat, though. There’s no guarantee that an active fund will be able to deliver index-beating performance, and many don’t. Research shows that relatively few active funds can outperform the market partly because of their higher fees. The problem is that if the managers’ fees are 2% and the index has an average return of 7% per year, the manager will need to gain at least 9% for you to be coming out on top.

Active vs passive investing can deliver significant returns over the years. However, work has to be done to manage and research the stocks in the portfolio actively. Regardless of performance, you’ll end up paying more in fees for an active fund. So to summarise, your manager will need to deliver consistent gains above their fees and benchmark for you to have positive portfolio growth.

Passive investing

Passive funds are also known as passive index funds. These funds are built to replicate a given index like the SP500 or healthcare. The best thing about passive income is that it mostly removes any human interaction and emotion and pairs that with generally lower fees. Most passive traders look towards the passive ETFs for their investing – like VOO or SPY, which both replicate the SP500. Instead of looking for the needle in the haystack, like active investing, passive investing just buys the whole haystack. So the risk evens out across all of the holdings instead of focusing on just a handful of stocks.

The volatility of the passive ETFs is lower, as well as the fees generally associated with it. Fees for both active and passive funds have fallen over time, but active funds still cost more. In 2018, the average expense ratio of actively managed equity mutual funds was 0.76%, down from 1.04% in 1997, according to the Investment Company Institute. Contrast that with expense ratios for passive index equity funds, which averaged just 0.08% in 2018, down from 0.27% in 1997. So, whilst the difference between 0.76% and 0.08% might not seem like a whole lot, it can add up over time.

Using $10k invested in each of the funds, passive investing (lower fees) works out to be around $3.1k better off (i.e. you have more money) in the timeframe of 20 years. In this example, they both have the same 5% return each year.

Hybrid portfolio

What I invest in is a hybrid of the two scenarios. Although I pick the single stocks myself, negating the need for a fund manager. I have about 65% of my portfolio in single stocks that I’ve researched and believe will outperform the SP500 over a period of 5 years. However, I also hold several ETFs that reduce my risk and provide that slow and grow holdings. I believe this is the best mix of holding. It provides aggressive growth from the single stocks but is balanced but the conservative growth of the ETFs. So, this helps me because I don’t have to manage 1/3 of my portfolio. The rest is done through ETFs so that I can focus more time on those individual holdings.

What have we learnt about active vs passive investing?

If you have very little time to research or pay money for a financial advisor/manager, consider passive investing. Whilst the returns may not be glamourous, the compounded gains will add up significantly over a long period. So, if you want to be more involved in your investments, know how to conduct research on a stock, and have an extra bit of cash, then active investing will be the best for yourself. As always, look at your financial situation, your investing time horizon, and your risk tolerance before investing.