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Active and passive investing

What is the difference between active and passive investing?​

Ayabonga Cawe speaks with Investec's Lisa Stride and Fabrice Muhizi.

Active vs passive investing​

The central difference between the two investment approaches is around how often managers make investment decisions and review the portfolio.

Passive investing tracks rule based indices or portfolios of which the most popular type of rule is market weighted whereas active investment follows a more hands-on approach. The latter involves a team of research analysts and portfolio managers that construct a fund or portfolio with a certain mandate. The main objective is to beat the market benchmark. Active managers make investment decisions on your behalf, which is also why these funds come with an extra, but justifiable cost, given that the fund outperforms the market.

Chasing alpha​

Alpha is the excess returns earned on the investments above the market benchmark. It’s the bottom line for active investment management. Fund managers achieve alpha by continually analysing markets and accordingly shifting client’s investments to benefit from their findings.

Passive investing is the cheaper of the two approaches but these fees are justified if fund managers are continuously beating the market.

In many cases, passive funds outperform active funds in the long run, but there is a subset of active fund managers that have been able to show results in the long run. You want to invest your money with these managers. A passive investor can’t outperform the market, as their return is the market benchmark minus the fees.

But selecting the winning manager is very a difficult thing to do and is akin to picking the winning stocks. The S&P Dow Jones Releases the SPIVA Scorecard yearly. In this report they compare performance of active managers against their indexes.

Wealth creation is long term game so on the SPIVA Scorecard for 10 year+:

  • Global Equity only 3.33% of fund managers outperforms the index and on the
  • Local Equity only 4.58% of fund managers outperforms the index.

If you also take into account its not always the same Fund managers that beats the market as they shift in the rankings every year, it makes choosing a winning active manager very difficult.

Another thing to take into account is when choosing an active fund is fees a Morning Star did a study showing that fees are the biggest predictor on Real Returns of a fund. And cheaper funds normally performs better

So, active or passive?​

The most important thing is to start investing. You can go months with analysis paralysis trying to decide what is the best method. But in most cases you can switch later there is a fee associated with fund switching but long term the opportunity cost of not entering the market is higher. And the easiest to start with is a broad based index fund.

Decide which type of investor you are. Is market returns enough for you or are you chasing alpha and accepting the risk that comes with chasing alpha. Or do you want to tailer the investments to your risk profile. If you are new to investing consider talking to a Financial Advisor preferably one that charges an hourly rate rather than a portion of assets under management.

And do your own research when you have the opportunity. If you’re paying for a service, such as active management, it must be justified by the value provided. You also don’t have to stick to one approach, there’s a place in a portfolio for active and passive managed funds.