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Summary
- While active investing is about making investments based on the stock market movements, passive investing relies more on long-term investment outlook.
- Both investment strategies have merits and demerits.
- Thus, it is for an investor to decide which strategy suits his or her needs.
One of the most debated topics across the financial world is the choice between active and passive investing. While active investing is about making investments based on the movements in the stock market, passive investing considers long-term investment outlook.
Both investment strategies have merits and demerits. Thus, it is for an investor to decide which strategy suits his or her needs.
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What is active investing?
Active investing generally seeks to beat the average returns of the stock market and take full control of short-term price fluctuations. The strategy requires a hands-on approach typically by a portfolio manager. An active fund manager doesn’t follow an index and can make changes to the investment portfolio depending on his or her market reading.
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A portfolio manager generally works with a team of analysts to analyse the qualitative and quantitative factors that can impact a stock or bond. This is how they take a buy or sell decision.
Advantages
- Active fund managers have flexibility to not to follow a particular index. They rather track stocks with high return potential.
- Active managers can also hedge their bets via techniques such as short sales or put options.
Disadvantages
- An average expense ratio for an actively management fund is relatively higher than that of a passive fund. The fee is on the higher side because all that active buying and selling triggers transaction and other operational costs
- While active managers have the flexibility to buy stocks or bonds, which they think could give good returns, any wrong decision can prove damaging as well.
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What is passive investing?
As already discussed, passive investing is based on buy-and-hold mentality. Passive funds are confined to a limited number of assets. It eliminates the requirement to buy or sell frequently. Thus, passive funds are less expensive than active funds.
An index fund, which tracks one of the major indices like the S&P 500, follows a passive investment approach. The fund automatically increases its holdings by selling the stock that’s exiting and purchasing the stock that’s becoming part of the index as and when index modifies its constituents.
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Advantages
- Passive funds charge less fees than active funds since there is nobody picking stocks.
- The level of transparency is more since it is always clear which assets are part of the index fund.
Disadvantages
- These funds are limited to specific indices or predetermined investments. The returns are restricted to these holdings irrespective of what happens in the market.
- Passive funds generally don’t beat markets in terms of returns as compared to active funds.
Active or passive investing? Which is the better option?
Even as passive funds are more popular due to lower expense ratio, investors have recently started to pick up active funds too to benefit from the expertise of an active manager. According to several investors, such an expertise can guide them amid volatility and wild market price fluctuations.
However, you are advised to choose between the two based on your targets and risk appetite. There is no one best fund for all as expectations vary from investor to investor.
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