What is the active versus passive debate?

Active and passive investing are often presented as polar opposites and providers from each side criticise the other. This can lead investors to think they should choose one over the other.

A growing body of investment professionals, however, believes the best outcome is a bit of both.

The passive argument

Passive investment providers often emphasize that:

• Many active fund managers do not achieve returns that beat the market;
• It is difficult to pick the managers that do so consistently over time;
• While active managers offer the potential to earn returns above the market, there is no certainty that they will deliver;
• Choosing an active manager introduces investment risk as you may choose a manager that underperforms the market;
• Index-tracking investments are cheaper than actively managed investments; and
• Index-tracking investments will always deliver the market return less their low fees and other costs and taxes.  Read more: What is passive investing?

The active argument

Active fund managers research and then select individual shares or other securities to buy or sell at different times with a view to delivering a return better than that which the market delivers. Read more: What is active investing?

For this, they generally charge higher fees than what you will pay for an index-tracking investment.

Active investment managers point out that:

• Passive investments will always underperform the market;
• Active investments have the potential to deliver returns that can beat the market even after their fees and other costs and taxes have been deducted;
• Passively managed funds may be more volatile than actively managed funds – actively managed funds may fall less when market prices are falling generally; and
• Investments that track indices in which securities are weighted in line with their size in the market, will typically invest when securities are expensive and sell them when they are cheap.

The blended approach

Some investment professionals believe the active versus passive debate is not an either/or one.

They recognise that at certain times in the economic cycle and in certain markets, it is easier for active managers to outperform their benchmarks.

It is easier for active managers to outperform when markets are not well-researched. In big well-researched markets, like those in the United States or Europe, it is more difficult for active managers to get hold of information that gives them a competitive edge.

In these markets, many investors know the value of the securities on the market and they trade at prices close to the securities’ fair price. Any new information about, for example, a company listed on a market is quickly communicated to all investors.

In these kinds of markets index-tracking investments can be a good option.

Index-tracking investments are also a good option when markets are rising. Active managers with the ability to manage the risk of losses may be a better bet when markets are volatile - prone to ups and downs – or falling.

Active managers can also do well in poorly researched markets or parts of them, because their research allows them to identify shares, bonds or other securities that are likely to do well in future, or are trading below their fair price and likely to increase in value.

In smaller, less-researched markets like South Africa, active managers have a better chance of being able to outperform.

In bond markets when interest rates are likely to change, an active manager who can manage the average duration, or period to maturity, of the bonds held may be a better bet than a passive manager.

The small cap equity sector is generally regarded as one suited to active investment as the shares need greater analysis and may not be easy to trade – they are illiquid.

In private equity and alternative markets, investors will also find few or no index-tracking investments.

The outcome

Using active managers where it makes sense to do so, and passive managers where there is less opportunity for an active manager to outperform, enables you to lower the cost of your investments.

A portfolio of investments with active and passive managers may, however, have a higher volatility than one with active managers only, so you may want to consider your ability to take and tolerate investment risk. Read more: What is my risk profile and why does it matter?

Core and satellite

When blending investments, you may be advised to invest a large proportion in one kind of investment to make up the core of your portfolio, and to add managers who select different securities or follow different styles in smaller proportions. This is known as a core-satellite approach.

For example, you could complement a passive investment that gives you broad exposure to an equity market, with investments in one or more high-conviction active managers with exposure to mid- and small cap shares. These managers are likely to perform well at different times, giving you a more constant return.

Make sure you combine complementary investment styles rather than double up by investing with two managers with the same investment approach, as this increases your investment risk.