Active versus Passive Investing

You may have heard the terms ‘active’ and 'passive’ in terms of investing but what do they mean?

As the name suggests, active investing denotes a strategy where a portfolio manager or team selects investments actively based on fundamental research, expertise and experience.

Passive investing is used to describe a strategy where an investment tracks a reference index, such as a stock market or a commodity index. It does this by purchasing holdings in all of the components of that index; for example, a fund that tracks the S&P 500 index, which represents 500 large listed companies in the US, would buy stocks in all of the companies that make up that index. A fund of this nature is called an index tracker.

Active funds seek to outperform the market, whereas passive funds seek to replicate the tracked reference index; passive funds are therefore not expected to provide any outperformance of the tracked index.

One significant differentiator between active and passive funds is cost.

Passive investment funds hold components of an index for long periods, until those components change, so there is a low level of trading and therefore fewer transaction costs. Active funds charge higher annual management charges to pay for active management and research, whereas passive fund management charges are very low in comparison.

An active fund can be more flexible in different market conditions as it can dynamically change its composition and hedge against certain risks, such as currency risk for example by using currency hedging. Passive funds are tied to the performance of the underlying companies in the tracked index.

Of course, active managers can also make bad calls, which can impact returns.

Exchange traded funds are one example of a passive fund.

Past performance may not be repeated and should not be used as a guide to future performance.