Active or Passive Investing?

Being active is one of the most prescribed messages from doctors. An active lifestyle doesn’t only help in losing weight, it’s rather an essential part of being fit & healthy. While physicians might be prescribing being active to improve one’s physical health, an increasing number of “financial doctors” around the world are asking their clients to become passive, in an effort to boost their financial wellbeing. This trend has recently started to emerge in India as well.

The active vs. passive debate is one of the most widely discussed topics in the world of investments.

Since it’s a very relevant one for most investors, it’s very important to first exactly understand what these terms mean. What makes an investment active or passive? Is it for how long you hold it? Is it the management style? Or is it how frequently you trade? While there are numerous definitions floating around, we define these two investing styles as follows:

Active: is when an individual/team/fund handpicks stocks or securities, taking active calls depending on market conditions and their subjective market views

Passive: is when an individual/team/fund follows a systematic rules-based approach to selecting stocks that is predefined and doesn’t involve any “active” or subjective calls

At its simplest, investing passively could mean buying a popular index like the Nifty-50 via a passive index fund or an ETF – since indices also follow a predefined systematic methodology, this would be a passive investment strategy that aims to replicate the return of the Nifty-50. What this means is that any amount you invest, the strategy/fund will allocate that money across the 50 stocks in a manner that’s pre-defined by the NSE (in this case, it’s based on the market-cap of the stocks).

Its “active” equivalent would be a large-cap fund where the manager aims to outperform the Nifty-50 (i.e. generate returns higher than it) by investing in a manner different from the Nifty-50 index. Usually, this is the responsibility of a fund manager, who employs various teams (researchers, portfolio managers, etc.) & resources (news/data subscriptions, computers, analytical softwares, etc.) – all of which, of course, comes at an additional cost, including the fund manager herself/himself!

And that’s the key problem with “active” management – the associated costs. For many years now, research and data have consistently shown that lower-cost investments tend to outperform higher-cost alternatives. That’s because the markets are unpredictable, but costs are forever – and the lower your costs, the greater your share of an investment’s return.

Interestingly, one of the biggest advocates of minimising expenses via investing in low-cost funds has been Warren Buffett – widely considered to be one of the greatest active investors. While he obviously believes in active investing, the one investment advice that he’s consistently offered for the general public has been to invest in low-cost strategies/funds. In fact, in his 2013 annual letter, he mentioned this is primarily how he’d like the trustee managing his wife’s money to invest after his death:

“My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will…My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds & 90% in a very low-cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”

And this guy knows some of the best investors in the world – yet, this is what he has willed. Such is Warren Buffett’s confidence in this low-cost strategy, that in 2007 he even took on a very public $1 million bet against a hedge fund manager, saying that active hedge funds wouldn’t outperform an S&P index fund over the next 10 year period. Unsurprisingly, he won that bet at the start of this year.

The Active Rise of Passive Investing

While passive investing has been around in theory since 1960s and in practice since Jack Bogle launched the first index fund in 1976, it only gained widespread popularity in the last 10 years since Lehman Brothers collapsed in September 2008 and the entire global economy got engulfed in a financial crisis.

After the financial crisis, institutional & retail investors started to embrace the research & data, which showed that it’s very difficult for managers to consistently beat the market.

The costs associated with active investing became very difficult to justify for most investors, and as such the focus shifted to keeping costs low by investing in passive strategies. Some active investors, of course still outperformed the index & even made money – but a large majority of investors also finally started realising that active management just wasn’t worth it. And it highlighted another issue: that while it’s difficult to outperform the market, it’s perhaps even more difficult is identifying in advance which funds/strategies will outperform.

Index funds, the original passive investing strategy & by far the most popular, have seen a massive increase in demand & fund inflows, with its AuM increasing 5x over the last 10 years to hit $10 trillion! A January 2020 article by the Financial Times writes that “Index funds have gained the most ground in equities, and above all in the US, where it has proven particularly difficult for traditional, active stockpickers to consistently beat their benchmarks. The past year has been no exception.”

But remember, the real debate isn’t between active vs. passive – it’s primarily between low-cost vs. high-cost & systematic vs. subjective

Active and passive just happen to be on opposite sides of both these arguments. If tomorrow active investing is available at a lower cost than passive, I’m certain this debate will again evolve, and many advocates of passive will have to rethink their position.

But until then, consider becoming actively passive for your long-term financial well-being, by investing your money in low-cost & systematic strategies.

Happy investing!