The active versus passive investing debate
04 March, 2015
Every week, hundreds of thousands of New Zealanders conscientiously choose their lucky Lotto numbers in the hope of winning the big one. Others take a Lucky Dip, relying on a randomly selected number sequence to bag the prize.
If you replaced the Lotto draw with the sharemarket, those who picked their own numbers would be called active investors, while those choosing a Lucky Dip would be known as passive investors.
Active investors think they can pick out just the stocks that will have the greatest return. A passive investor is happy to rely on the market overall to give them a return, rather than picking stocks that will beat the market.
The analogy is not perfect because Lucky Dip owners don't always win something, whereas passive investors always get a return that matches the market. Of course, it could be a negative return.
Passive investing involves buying an index fund, a portfolio of all the stocks in an index which represents a portion of the overall market. An example is the NZX50 Index which contains the 50 largest companies listed on the New Zealand Stock Exchange, weighted by their size.
A passive investor's portfolio will match the composition of the index, so its return will be the same as the index return.
An active investor's portfolio will aim to beat the index by holding more of the stocks expected to perform better than the index and fewer of the stocks expected to underperform.
There have been countless academic studies and comparisons undertaken over the years to determine which is the better investment method. The results have been inconclusive.
Passive funds have beaten active funds a lot of the time, largely because they are generally cheaper than active funds because less time and resources are spent on research and trading.
But there are also lots of examples of active funds beating the market over long periods of time, often by a significant margin.
Just to complicate matters, sometimes active investors are relatively passive and some passive investments involve active decision-making — blurring the lines. One commentator recently introduced the concept of 'pactive', saying true passive investing is rare and, more often than not, active decisions are made by passive investors, rendering them pactive.
There is no doubt it's challenging for an active investor to pick the right stocks and get their timing right to allow them to beat the market return. However there is still merit in active investing.
A passive investor has to own all the stocks in their chosen index, even if there are valid reasons not to hold some of them. One example is the global fixed interest sector. Some investors choose to take a passive approach to global fixed interest, using funds that replicate the Global Aggregate Bond Index, which is the most widely followed fixed interest index in the world.
Unlike sharemarket indexes where the more successful and profitable a company is, the more it grows and the larger its position becomes in the index; fixed interest indices work in reverse.
The largest components of the Global Aggregate Bond Index are those countries that issue the most debt (i.e. they owe the most); the United States, Europe and Japan. It could be argued these are the least sound fixed interest investments, in terms of credit risk, and yet these three issuers comprise over 90 per cent of the index, forcing passive investors to accept a significant risk.
To me, it makes absolutely no sense owning shares in a poorly performing company, or bonds in a heavily indebted country or entity, simply because it is in an index that I am trying to beat.
At any major turning point in a market, investment opportunities can arise. After strong market rallies, some stocks can become overpriced, creating good selling opportunities. After big market downturns, some stocks can be seriously undervalued as they get "thrown out with the bath water".
A passive investment approach makes it impossible to take advantage of these opportunities.
That's why active investors enjoy picking their own rather than relying on the luck of the draw.