November 14, 2019

2 min read

Investment and Life insurance

Passive versus active investment management
In our last article we learned that it's possible to beat the market with active management – let's find out how active and passive investing differentiate from each other.
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Nicholas Flaherty, Investment Strategist at FWU Invest S.A.

When choosing an investment fund, it is vital to know whether you are getting an ‘active’ or a ‘passive’ fund, as it can have a marked impact on your return and the costs you will be paying. So let’s get you informed!

First off, what do ‘active’ and ‘passive’ mean in this context? Active means there are investment managers ‘actively’ choosing the securities that are going into the fund. Think of analysts/economists/portfolio managers analysing the economy, going through the balance sheets of companies, meeting company management – they are ‘actively’ choosing what they think are the best investments.

When it comes to ‘passive’ investment vehicles, things are different – there are no armies of analysts seeking the best investments, no one is ‘actively’ managing it. Indeed, the investment process is much simpler: it is a replication of an index, meaning no analysis is actually required. In practice, this means having a couple of ‘managers’ whose sole job it is to best copy an index, such as the Dax or the S&P 500. So, for example, the S&P 500 index contains 500 stocks, ranked in terms of size, defined as total market value, and the job then of the passive manager is to buy these 500 stocks in the same proportion as the index and thereby replicate its performance. No fancy charts or meeting management of the companies, just replicating the index.

Now, to the most important question – which one of these approaches is better? Well, as economists always say, it depends! The first thing to highlight is that passive investment vehicles are cheaper, as there is no need for analysis – it is essentially only copying. But as passive funds are always just copying the index and also taking fees, it means that, by definition, the return investors get will always be less than the index – they can be sure that they will never outperform the overall market!

With active investment, this is different, there is the possibility of beating the market, sometimes by a very large degree. But investors need to be careful because there are a lot of bad active managers out there. Just because someone wears an expensive suit and drives a nice car does not make them an investment guru. In fact, what many do is what is known as ‘closet indexing’, which refers to the practice of pretending to be ‘active’, but in fact just using the passive approach by buying the big stocks in the index. In this case, investors would be well advised to stay away from these managers and if there is no other choice opt for a passive approach, which can give them the same exposure but at a fraction of the cost. There are, however, active managers that have the skill to beat the market and thereby perform significantly better than simple index investing. There aren’t too many of these around, but it is exactly these managers that are worthwhile and ones that investors should be seeking out if they want higher returns than just the index. 

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