Investing is not an easy task, rather it requires a lot of strategy. The question of formulating an adequate strategy has incited a notable debate in the finance world, namely between active and passive investing. Thus, this article will explain these two concept and analyse the advantages and disadvantages of each one.
What does ‘active’ and ‘passive’ mean?
Naturally, each strategy has a different ethos. Active funds have human fund managers, who aim to beat stock market averages (the benchmark), often through individual stock picking. Passive funds, predominantly automated, don’t aim to outperform but rather they look to match a specific index. Due to their nature, active funds tend to have much higher expenses than passive ones, given the additional workload that is required to analyse specific investments. According to AJ Bell, in the UK, the average annual fee for active funds sits at around 0.86%, while for passive funds its rather 0.17%.
Pros and cons of active investing
The biggest perk of active funds is that fund managers are able to tailor the investments specifically to the investors. This allows for much more flexibility, as managers aren’t required to stick to a rigorous index. This means they can often stock-pick, actively buying and selling stocks they believe will outperform a certain benchmark, while also being able to sufficiently support the individual in any other wishes, say they wanted to only invest in ESG stocks. Finally, active fund managers may also be better at shielding you from market downturns. They can more easily change troubled investments and look elsewhere, meaning they have better tools for defence.
Nevertheless, there are downsides to active funds. As mentioned, they are significantly more expensive than passive funds. When considered from a long-term perspective, this can have a noticeable impact on overall returns. Furthermore, there is also the question of higher risk. Active fund managers are looking to outperform the benchmark, meaning they could find themselves picking more risky or volatile stocks to try and achieve this. Even the most able fund manager isn’t guaranteed to give you the return you are looking for. Adding to this is also the possibility of human error. Active funds, as opposed to passive funds which are automated, are normally fully run by humans, meaning there will always remain some liability in terms of mistakes that a fund manager could make.
Pros and cons of passive investing
Passive funds have much lower fees, since they don’t require human managers, being automated with at most a little human oversight. This is incredibly useful as this results in a minimal detriment to your returns through the fees. They are tied to an index, and aim to match it. This is relatively tax-efficient, as this strategy doesn’t tend to incur a huge amount of capital gains tax. Finally, they also offer significantly more transparency. While active portfolio managers will seek to stock pick to find you a helpful strategy, passive funds are tied to a specific index, say the FTSE 100 or S&P 500, which are easy to find and view.
Passive investment funds don’t have the same protective mechanisms as active funds. As they are tied to a specific index, if that index goes downhill, so will your investment. You also will not have the same flexibility, as your investment is wholly dependent on the stocks contained within the index. This can lead to being overly exposed to one specific type of asset or market, or be unable to direct where your money is going. Additionally, you will not be able to expect very high returns. The fund is aiming to stick to a benchmark, rather than aiming to beat the market, meaning there is no possibility of the high returns that may be feasible with an active fund.
Thus, both types of investments have their advantages and disadvantages. Passive investing is cheap, and tends to have a greater chance of producing returns as the majority of active portfolio managers seem to underperform their benchmark. As such, passive funds are simply a safer options that allow for gradual accumulation. It is important to note a selection of passive funds will still have to be selected, so therefore there is inevitably going to be some degree of choice required. Whether you prefer to use active or passive investments it’s worth speaking to a financial advisor, as they will guide you through a number of options available to you.
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