Panorama article

Definitions

First, what is active or passive investing?

In simple terms, they are two alternative investing strategies: passive investing aims at duplicating the performance of a benchmark (say the S&P500 for US equities, for example) while active investing aims at beating it.

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Key differences

Active investors – normally professional fund managers .- spend a lot of time and attention with their analyst teams to find ways to beat the market: they search, and then buy or sell, selected individual securities that are expected to perform better than the assets in the benchmark of reference.

It is clear that successful active investment management requires being right more often than wrong.

On the other side, passive investing is much more hands-off: once you buy a specific market (= the shares of index funds or ETFs), there is nothing else to do. It is a buy and hold strategy not trying to react or anticipate the stock market’s every next move.

Passive investors limit the amount of buying and selling within their portfolios, making this a very cost-effective way to invest.

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Pros & cons

The immediate advantages of passive investing are cheaper fees, easier management and immediate diversification (because of investing in entire markets), but there is no way out in case an entire market under-performs over time.

Active investing offers flexibility and potential over-performance in bear and bull markets, if done well, but it often fails to deliver.

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So which one to chose?

Study after study (over decades) shows disappointing results for the active managers vs passive investment vehicles, with active mutual fund managers across countries consistently underperforming their benchmark index in more than 90% of the cases, often because of their higher fees.

This is true for several asset classes, and especially the better-known ones, from classic stock markets to plain vanilla bonds.

It is less true in markets and assets that are less mainstream, think about emerging market fixed income for example: active investing can be more useful in less common markets, in illiquid assets or little known securities, or portfolio holdings tailored to specific purposes, such as minimizing losses in economic downturns.

Active and passive strategies tend to work best over time for different portions of anyone’s portfolio: active strategies have tended to benefit investors more in certain investing climates (with higher volatility), and passive strategies have tended to outperform in others.

To get the best of both worlds, here at Monetharia we are developing an active basket of passive indices that is managed dynamically.

In practical terms, we are developing an all-weather investment portfolio that uses only passive funds (cheaper, easier, better diversified) but it allocates to them actively, with specific weights that dynamically change over time according to where we are in the economic cycle.

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