Active investing vs passive investing

Investing can be very tricky when it comes to maintaining your portfolio. Your portfolio says how your stocks are performing. And the periodic recording of how this goes keeps you updated on how your portfolio is performing with respect to the current market. By this, you can decide which stocks to keep and which stocks to replace.

While passive investing is more popular among investors, there are arguments to be made for the benefits of active investing, as well.

Active investing

As the name implies, one has to actively look into the portfolio and keep maintaining the portfolio throughout the tenure of keeping the stocks. The goal of active money management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations. This requires a much deeper analysis of the market and deciding the particular stock or bond to buy.

A portfolio manager guides a team of analysts who look at qualitative and quantitative factors, then try to determine where and when that price will change. By this, the analysts can predict the right time to buy or sell.

Active management includes mutual funds and exchange-traded funds, as well as portfolios of stocks, bonds, and other holdings managed by financial advisers.

Advantages:

• Flexibility: Since they are actively buying and selling, they are not required to hold specific stocks or bonds.

• Hedging: The ability to use short sales, put options, and other strategies to ensure against losses.

• Risk management: The ability to get out of specific holdings or market sectors when risks get too high.

• Tax management: Including strategies tailored to the individual investor, like selling money-losing investments to offset taxes on winners.

Disadvantages:

• Expensive: Fees are higher because all that active buying and selling triggers transaction costs, not to mention that you're paying the salaries of the analyst team researching equity picks. All those fees over decades of investing can kill returns.

• Active risk: Active managers are free to buy any investment they think would bring high returns, which is great when they are right, but brings in hell when it goes wrong.

Passive investing

If you’re looking for the long run without touching your stocks, then this might be the best option. Passive investors limit the amount of buying and selling within their portfolios, making this a very cost-effective way to invest. This means you buy and hold, and wait.

That means resisting the temptation to react or anticipate the next stock market’s move.

An example of a passive approach is to buy an index fund that follows one of the major indices like the Nifty 50 or Sensex 30. Whenever these indices replace their constituents, the index funds that follow them automatically replace up their holdings by selling the stock that’s leaving and buying the stock that’s becoming part of the index.

When you own tiny pieces of thousands of stocks, you earn your returns simply by participating in the upward trajectory of corporate profits or the overall stock market. Remember, Nifty 50 constituents are the top best 50 companies in India. Successful passive investors keep their eye on the prize and ignore short-term setbacks- even sharp downturns.

Advantages:

• Low fees: You’re the one who is picking the stocks and there is very little maintenance. Passive funds simply follow the index they use as their benchmark.

• Transparency: It's always clear which assets are in an index fund- you know what all the constituents of an index are.

• Tax efficiency: Their buy-and-hold strategy doesn't typically result in a massive capital gains tax for the year.

Disadvantages:

• Limitations: Passive funds are limited by buying the index funds. Although there are different types of index funds available apart from nifty 50 and Sensex 30, these are limited.

• Limited returns: Passive funds will pretty much never beat the market as they go parallel with the market, even during times of tough times, as their core holdings are locked in to track the market.

Comparision

Serial Number	Particulars	Active investing	Passive investing
1	Strategy	Fund manager actively changes the fund’s composition at his/her own discretion	Fund manager only copies the movement of the benchmark indices
2	Expense ratio (Expense taken up by the portfolio manager)	0.08 to 2.25% depending on asset you have brought	Maximum 1%
3	Returns	Fund manager aims to beat the benchmark	In the range of the returns of the benchmark or lower

Conclusion

The difference between active and passive investment strategy is more a difference between its features rather than which category is good or bad. It all depends on the investor profile and his risk profile. The fact that an ETF directly maps an index is a passively managed fund’s feature.

To know more about ETF, click here.

If an investor can financially afford an active fund manager, then the risks and goals are in line with the active funds. However, if an investor does not want the fund manager to take too many decisions and risks, but wants the fund to simply map the benchmark, then passively managed funds should be the best option.