This is a guest post from Christopher Liew, the creator of Wealthawesome.com, where he shares money tips and guides for his readers. He’s a CFA Charterholder who has been featured on Yahoo Finance, MSN Money, and The Motley Fool. Read about how he quit his 6-figure job to travel the world.
Should you choose active or passive investing? Before the 2000s, the answer to that question would have overwhelmingly been active investing.
But over the last decade or so, the support for passive investment has been gaining much more momentum.
Purchases of exchange-traded-funds (ETFs) have exploded in popularity in both the U.S and Canada as a result of this growing trend towards passive investing.
What is Passive vs. Active Investing?
Passive investment is all about tracking and tracing. Rather than trying to outperform the market, your investment attempts to match its returns.
It’s a low-risk, low effort investing as you don’t have to critically assess the virtues of any specific investment. Instead, your investments are spread across multiple stocks via an index fund.
For active investments, the goal is to outperform the market benchmarks. This is done through individually assessing different stock options to see which ones are likely to give the best returns and continuously reviewing your investment portfolio – adding or removing stocks as needed.
Because most investors may not have the time or adequate knowledge to properly manage their active investment portfolio, the responsibility may be handed over to a dedicated fund manager instead.
In return for the service rendered, the fund manager charges a management fee – in Canada, it can be in excess of 2% of the total portfolio value which is extremely high.
Here are a few reasons why so many investors are choosing passive over active investing.
Time is your most valuable commodity because it is finite, and more of it cannot be bought. Given its worth, it is best to invest it as wisely as you can.
Having an actively managed fund can be a huge opportunity cost. The time and energy you spent researching and managing your portfolio could potentially have been better invested elsewhere, such as setting or expanding your own business, for example.
With an index fund, you can pretty much and set and forget. Sure, it might experience peaks and troughs due to market cycles, but the longer-term trend would be that of consistently good returns. Even the best active managers in Wall Street have not been consistently able to beat popular index funds like the S&P 500 for more than five years.
2. Lower Fees
Passively managed funds, by their low-upkeep nature, carry with them virtually negligible fees, with expense ratios below 0.2% being the norm. Actively managed funds, on the other hand, as noted, tend to charge a much higher fee.
This means that passive investors can begin each year with potentially a 1.8% head-start over active investors. Not only that, but they also don’t incur costs associated with trading fees, which, in actively managed accounts, can rake up to a significant amount.
So, on top of attempting to beat the market performance, active fund managers also have to beat the cost-lead that passively managed accounts tend to enjoy.
Lower fees are perhaps the greatest argument in favour of passive investing over active. Everyone wants to get the cheapest fees possible.
3. No Human Error
2020 marks the 10th year streak of passive investment beating actively managed stock funds in terms of returns for the S&P500. One reason is there can be overtrading and overconfidence of the active managers of the funds.
We might think of ourselves as rational, but the decisions we make tend to be heavily influenced by emotions, peer influence, and behavioural biases.
This is especially true with decision processes where a large amount of information is needed. Our brain then makes use of mental shortcuts to arrive at a decision, filling in the vast information gaps with whatever our feelings try to rationalize. This can lead active managers to make wrong decisions that can eat into their returns.
Passive investments, on the other hand, are largely free of human-induced uncertainty, being instead steered by the rational forces of the market. By simply buying an ETF with a very low fee, any investor can get access to hundreds or even thousands of stocks that will mirror the market precisely.
In a world with ever-growing markets and rapid globalization, this can only mean continuously high returns over the long run.
4. Trends Stability
Passive investments such as an index fund generally feature a high number of investors and asset distribution. This means that they generally are much more robust against the volatility of market trends.
For instance, taking a recent example, the S&P 500 Index has grown 11.3% year-to-date, despite the downturn caused by the COVID-19 crisis. This is because the loss from its underperforming assets (e.g., energy, manufacturing) was offset by the gains from its overperforming assets (e.g., IT, Finance).
Active investments, meanwhile, because of its much lower asset distribution, are much more susceptible to market trends. Depending on how the funds have been invested, the underperformance in one sector can deeply impact the overall performance of the fund.
Even actively managed funds that have consistently performed well can fall prey to volatility caused by market trends. Their success may attract more investors, and this can be negative in two ways.
First, the large flood of cash can lead to a style drift – the divergence of a fund from its original investment strategy. Second, once the streak ends, many of these new investors would just as quickly leave the fund, slowing the performance for the remaining ones.
5. Tax Benefit
To top it off, passive funds are also much more tax efficient. As we know, taxes are incurred on capital gains. However, if the stock remains invested for more than one year, the tax rate tends to be smaller. Most passive investments are made with long-term returns in mind.
Comparatively, the frequent short-term trading of stocks in actively managed portfolios incur a high tax rate and results in a significant portion of the gains being lost.
Active investment has its merits. However, for the majority of investors, passive investment stands out as a better option as it is more cost-effective, carries fewer risks, and boasts higher average returns over the long-run.