Difference between active and passive investing

Photo of Matthew Felsman By Matthew Felsman

min read

An active approach to investing makes sense in volatile, unpredictable markets.

One of the most controversial topics in finance is the “passive” versus “active” debate on investment approach, and there are subjective arguments to be made on both sides of the discussion.

The reality is that from the moment your capital is invested, the fact-finding, hypothesis and forecasts that your investment determination was based on has already become part of history.

When investing in financial markets we have to remember we are not dealing with logic, but with emotions, prejudices and motivations of greed and fear. Decisions are made indicative of what is possible, but markets are liquid and they move, new information is presented and things change.

Markets are places to buy and sell assets, but they are also treated like casinos and all casinos have a few scoundrels. We have to be wary that fees, taxes and commissions reward the smartest, the quickest or the ones who cheat; that’s just how business works. We have to consider there are rare events that occur beyond the grounds of calculation, therefore not foreseeable or foreseen.

Predicaments unfold and have major consequences, and can only be rationalised with the benefit of hindsight. We must acknowledge that markets prove the only things that are knowable are the past and the present, and even they are impaired. Markets are unpredictable.

How active and passive investing differs
Active investing involves choosing investments you believe will outperform the broader market surroundings. Passive investors try to replicate the price and yield performance of an index.

Locally, for the 2016 financial year the ASX 200 index fell minus 4.1 per cent. Even if you include dividends the total return of the index was an insignificant +0.6 per cent, and that’s before any fees, subscription bills and operation costs.

Comparatively, a term deposit in this era of record low interest rates even looks appealing at about 3 per cent. However, as an index the ASX 200 had significant moves from its August 2015 highs and February 2016 lows, declining and rising more than 15 per cent. More broadly, stocks outside of the ASX 200 significantly outperformed.

Passive management is often seen as a low-cost, low-governance way to invest. This may be true in a narrow sense, but it would be a mistake to believe it is low risk or offers a comfortable set-and-forget approach.

In its most common form, passive investing is buying a basket of stocks and holding them, riding the ups and downs, and typically trying to replicate a benchmark index such as the ASX 200.

For the average pension-phase investor or self-managed super fund director, this would look something like the big four banks, a few miners – say BHP and Rio – Telstra, the major Australian supermarkets Wesfarmers and Woolworths, and possibly a few healthcare or industrial names.

Regardless of market movements, the strategy is “long and strong”, holding at all times. The only time these investors develop any intuition is when there is a major market movement that generates enough press coverage to gain their interest.

As we pointed out above, the bulk of set-and-forget, long-term investors have been hammered in the past year by their focus on the top 200 stocks and by their own inaction. Returns can be generated during market volatility by accumulating or lightening holdings and not being afraid to look for smaller companies that are growing.

Chart 1: The top 20 stocks performed worst in the 2016 financial year.

I would argue that the most important investment decisions are unavoidably active and that there are hidden risks to index-based investment approaches. Passive investing by definition is flawed; that is, not reacting to something that might be expected to produce manifestations.

That really means buying yesterday’s winners and taking a set-and-forget approach, with the emphasis on “forget”. It is not investing, it is being invested, and while passing as “low risk” or “sophisticated”, it is irrational.

Passive investing is forecasting. The impulse of 2016 in many aspects has been to do the exact opposite of what feels right, anticipating the unexpected.

While writing this article I was reading over a Bloomberg story written in December 2015, titled ‘A Pessimist's Guide to the World in 2016’.

Bloomberg News asked dozens of former and current diplomats, geopolitical strategists and economists to identify the possible worst-case scenarios, based on current global conflicts, which concerned them most heading into 2016.

I remember reading it at the time and thinking how the events they described seemed so entertainingly impossible. Here are a few of the scenarios, unfolding almost on cue:

  • In the UK, David Cameron calls a referendum in June eager to end the uncertainty over Britain’s future in the European Union. London Mayor Boris Johnson decides to challenge and taps into anti-establishment populism and fear about the influx of refugees. The UK votes to leave the European Union, Cameron resigns, the pound slumps, the FTSE crashes.
  • Oil-rich regions in West Africa, such as the Niger Delta, are subject to violent attacks from militants, driving the oil price up on supply concerns.
  • The rise in oil prices stops the US Fed tightening cycle.
  • A series of Paris-style terror attacks in European cities triggers a crisis.
  • The US sails warships into disputed waters in the South China Sea, lending support to a new anti-Beijing government in Taiwan.

The point is, making very long-term convictions based on the evidence available to you now, or at this given time only, runs counter to the statistically obvious. What seems impossible today is possible tomorrow; investment decisions need to be reviewed constantly, questioning and updating integrity.

It was billionaire investor Warren Buffett who famously stated that "diversification is protection against ignorance”, meaning it makes little sense if you know what you are doing.

In Buffett’s view, studying an investment theme or strategy, learning the ins and outs, and using that knowledge to profit, is more lucrative than spreading investment funds across a broad array of companies and sectors so that gains from certain areas offset losses from others. Understand what you are doing.

Chart 2: The 2016 financial year results by individual stocks

Selling is 50 per cent of the investment process, but it only receives 5 per cent of the attention. You must engage with the performance of your own investments on a regular basis in order to develop any understanding and to have any chance of knowing when to act. This will lower your risk of losses and give you a chance of timing the tops and bottoms in stocks. Pay attention and don’t be afraid to sell.

When markets are inefficient and when following an index leads to negative returns, it is the job of an adviser to assist. The ability to add value through stock selection is the cornerstone of active investing, and will typically mean buying and selling stocks in an effort to maximise returns – stocks you might not have even heard of or considered.

Markets are irrational and they can remain that way longer than you can remain solvent. Too much emphasis is put on deciding which stock to buy and thinking that is the end of it, but it denies the fact that anything can happen next.

You need to know what companies you own and why you own them, what companies you are planning to buy if the share price dips or the market crashes, and at what price. What are your target prices to sell for each holding in the portfolio and why?

It is time to be smarter with stock selection and have an open mind to changing from what has worked over the past 20 years to what is likely to work in the next 20. That’s active investing.

About the author

Matt Felsman advises institutional and high-net-worth investors at APP Securities. Connect with him on LinkedIn: https://au.linkedin.com/in/mattfelsman.

Follow him on Twitter: @mattfelsman 

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