The two ways of investing – active and passive; what’s your choice?
The passive-active investment debate is not a new one, it goes back to 1975 when the celebrated American investor John Bogle, founder The Vanguard Group, created the first index fund.
Both have backed the theory that slow and steady wins the race.
You have heard Aesop’s explanation, the hare-and-tortoise story, since childhood. Buffett’s is less fantastic and more contemporary; it is expounded in page 20 of his letter to his company’s shareholders in 2013, explaining what he wants to is done with his money after he is gone:
My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.
What Buffett is basically endorsing is a steady, passive investment strategy. In the long term, he believes, one will make better returns than the vast majority of investors who employ more expensive, active investment strategies.
So what is passive investment – or for that matter, active investment?
The passive-active investment debate is not a new one, it goes back to 1975 when the celebrated American investor John Bogle, founder The Vanguard Group, created the first index fund. It was his hope that small investors would find it simpler and cheaper to gauge market performance by tracking this index fund, instead of engaging expensive pros at mutual funds. The concept gave birth to passive investment and has since then revolutionised investing. But it also invited critics, giving birth to which-is-better debate – passive, or active?
Passive investing is based on a “buy-and-hold” strategy, where the investor avoids taking any additional risks and makes investments in line with the index that the passive fund is tracking. Basically, the fund need not do more than buying and selling in the closest proportion to the index, ensuring that its earnings are in line with the market average. These investments are usually in assets with low turnover, diversification and defined investment horizons. Also, its stand-out feature is the low fee associated with it, as it excludes high-fee fund managers.
Here, decisions are taken by professional fund managers, who aim to pick the right investment, beat the market average, exploit short-term price fluctuations, and generate high returns in quick time. These investment decisions could be related to selecting stocks, timing the investment, choosing the asset class etc. In India, such funds generally yield returns higher than the indexes and are common in equity funds, debt funds, hybrid funds or a portfolio of such funds.
Which is better?
Weighing Passive Investments
In the West or developed markets, the preference is for the passive investment strategy for a host of reasons, one being the lower fees involved in comparison with active investments. The management of passive investments requires very little human intervention, which means the investor stands to save a huge amount of money on the fees of professional fund managers.
In India, the charge for managing passive funds with assets under management valued at over Rs 500 crore each is 0.12%, while it is much higher at 1.73% for actively managed funds.
There are other factors going in favour of passive investments, these being:
- Tax efficiency: The buy-and-hold style means the investor does not have to pay large annual capital gains taxes;
- Transparency: The investor is never in the dark about which assets are in an index fund.
On the flip side, passive funds restrict investors to a specific index or fixed set of investments, despite what happens in the market. Plus, returns are small, as these investments never really manage to beat the market, even during volatile phases.
Weighing Active Investments
The biggest advantage with active investing is the flexibility; managers are not required to follow a specific index and ‘stray’ in search of stocks with potential. They can also hedge their bets and exit stocks when required.
On the negative side, they can be risky and are very expensive.
Investment and returns know no gender; the risks are the same for men and women, and so are the returns. So what’s holds true for men when it comes to choosing between also holds true for women. However, if you are not a veteran or professional investor, it can be a good idea to know what Barclays Bank has to say on the subject of what might be right for you in this regards.
According to Barclays, the “right” investment for you – active or passive – will depend on several factors:
- Your investment goals
- Your risk tolerance
- Your confidence in active managers
It also points out that the developed markets such as the US and the UK are so widely researched, emerging markets (such as India’s) are typically less efficient. In such cases, Barclays says, investors can benefit from the knowledge and experience of a fund manager, “although there are no guarantees”.
Whichever investment route you choose, or whether you go for both, do remember that either way your punts can still plunge in value. If you are not totally convinced about where to invest, it is best you take professional advice. That is also the more prevalent method in India.