Active vs Passive Investing: Which strategy should you follow?

An investor posed a question to me recently: “is active or passive investing was the best approach to take?” The truth is that both approaches have their advantages and disadvantages when considering different investment strategies. Hence, there is no cut and dry rule on which approach to follow.

An active strategy is employed when you invest with managers, such as a specific equity unit trust fund, that make specific investment decisions with the aim to provide alpha (performance after fees above the return of a specific index). Passive investing, on the other hand, is the approach adopted when an investor believes that a manager will not be able to return the performance that an index will be able to deliver, on a net of fees basis. This results in an investor then selecting an investment that tracks a specific index (such as an Exchange Traded Fund [ETF]); the aim of the passive approach would be to replicate the index, and its return, at a lower cost than going through an active manager.

One of the arguments in favour of passive investing is this approach is far more cost effective thereby preserving a greater portion of the investment capital by not eroding it with high fees. One should be aware that through a passive approach, an individual may theoretically under-perform the index they are tracking given the fees charged by an ETF. An active approach may offer the opportunity to provide returns greater than the respective index in consideration; however, according to ETF SA [1], 82% of South African active managers fail to outperform the market. It is therefore important to ensure a manager does not adopt a “closet indexing” approach to managing your money; why pay for active management if the managers pretty much track the index? The decision to use an active or passive approach should never be solely based on costs. An experienced Wealth Planner will also be able to help you select the appropriate investment portfolio.

An investor must remember that asset allocation will dictate a large portion of the investors risk and return profile; asset allocation is how much, as a proportion of your total investment, you allocate between the various asset classes such as equity, property, bonds or cash. This needs to be taken into account for both active and passive investment approaches. Simply picking a number of passive ETF’s or active Unit Trusts may not result in a good strategy, one may end up using an approach that is detrimental to your investment objective, such as being in a single asset class.

My view is that an investor who has no knowledge of a specific market should aim to adopt a passive approach until they can find a fund manager with a proven track record of outperformance on a net basis. This is especially true if you invest smaller amounts on a monthly basis and cannot afford to have fees erode your investment balance.

The bottom line is that having a bias against, or for, one style of investing, could result in a wealth strategy that ignores the potential benefits of the other solution. An investor should always discuss the reasoning behind their portfolio management direction with their financial advisor prior to making any decisions.

Robert Starkey RFP™
Wealth Planner