Passive vs Active investing

The argument surrounding passive vs active investing revolves around which style of investing can consistently outperform one another.

Article updated: 10 February 2021 9:00am Author: Joe Healey

Active managers and investors believe that a manager’s expertise and in-depth research can allow active funds to capture opportunities as and when they arise; thus consistently producing alpha (outperformance) over benchmarks. Of course, this close management comes with additional cost and therefore investors expect performance to exceed the benchmark to justify this.

However, over the past few years we have seen an increasing appetite for passive investments as performance has been relatively close to active counterparts and in some cases outperforming. Passive investments do not necessarily tend to beat benchmarks but aim to track them as closely as possible meaning they are more of a longer-term investment choice. This style of investment has become popular not only because they are cheaper than their active counterparts but also because investors can gain exposure to a much larger basket of companies which provides a cost-effective way of achieving diversification.

When comparing performance, it is important to remember the fundamentals behind efficiency in markets to determine where active managers can truly add value. For example, the US S&P is one of the most covered indexes in the world and could be assumed to be an efficient market meaning market discrepancies are quickly priced in offering little potential to exceed benchmarks. If we look at performance over the last five years of a sample of US ETF’s tracking the S&P 500, they have an average return of around 132%. If we compare an active fund sample tracking the same index, the average return comes in at around 133% highlighting the narrow impact in this market.

If you switch this perspective to other international markets such as European active funds, we see that funds have returned an average of 80% over a five-year period compared to a passive fund sample where average returns are roughly 76% highlighting a slightly larger gap.

Despite these differences, there are always going to be investors that prefer the comfort of having a professional manager making informed decisions on portfolios. What is important for investors to consider when making decisions on these types of strategies is whether they believe market efficiency is great enough to warrant a passive strategy. Of course, in certain market environments this may change and the extra cost for active funds may be deemed to be worthwhile.

*Data supplied from FE Analytics


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Joe Healey

Investment Research Analyst

Following his completion of the graduate scheme, Joe is an Investment Research Analyst covering equities. He holds a BA Hons Business Management degree and is currently studying towards CFA Level II after passing CFA Level I in June 2019.