Hima Bindu Kota
For most people, there’s a time and place for both investments as well as savings. Combining active and passive investments can diversify a portfolio and help manage overall riskOne size does not fit all as far as investment strategies go. People are unique in their preferences, tastes, needs and requirements, and so should be their investment styles. Depending upon their risk appetite, investors can either choose to invest passively and shadow any well-known index or take a hands-on approach to active investing. Over the years across the world, there has always been a heated debate about which strategy, passive or active, is best to make more money for the investors. And interestingly, the answer is different for developed mature markets and emerging immature markets
These two strategies differ in their investment philosophy. Passive investors do not look at beating the market and are contented to mirror investment holdings of a particular index; whereas active investors focus on outperforming a specific benchmark. Passive investment, endorsed by the legendary investor, Warren Buffet, is long-term in nature, where returns are generated due to the natural upswing of stock markets, ignoring short-term setbacks and even sharp downturns.Passive investors believe that historically, over the long-term, stock markets have always moved on an overall upward trajectory. Since passive investors naturally have a limited amount of buying and selling of stocks and with less oversight fees, they tend to have a ultra-low cost, in addition to transparency, as it is clear which assets are to be bought and in what proportion, and tax-efficiency. The simplest way of embarking on a passive approach is to buy an index fund that follows one of the major indices like the S&P 500, Dow Jones and BSE Sensex and Nifty in India, like HDFC Index Fund —Sensex, UTI Nifty Index Fund, to name a few.
These index funds automatically adjust their portfolios to any new additions or deletions to the original index in the same proportion. Passive investment is for conservative and risk-averse investors who are looking for low-risk investment and are not overly concerned with seeing rapid gains. The idea behind the passive approach is the classic value investing style which looks at long-term benefits of holding on to undervalued stocks with huge future earning power. Active investing, on the other hand, is an approach that aims to generate above-market returns by an in-depth research and analysis and using the knowledge and expertise to manoeuvre into or out of a particular stock, bond or any asset, and taking full advantage of short-term price fluctuations. Since active investing does not necessarily mimic any index, it provides flexibility of buying stocks which could be hidden gems. As active investors are not stuck with index stocks, they are able to exit any sector or stocks, when the risk becomes too high and can also hedge their bets using various techniques such as short sales or put options. However, all the research overheads and frequent buying and selling make active investment very expensive. It is also a highly risky affair since higher returns can only be expected when the going is good but things can go terribly wrong during market downturns and, therefore, due to its volatile nature, active investment strategy is better suited for investors who are aggressive and risk tolerant. In passive management, one rises and sinks with the ship whereas actively managed funds have the ability to provide greater opportunity for profit than their more stable passively managed counterparts, albeit, increasing the risk of investors manifold. Active investors are more focused in improving their “alpha”, the metrics to assess either the excess performance or underperformance relative to the benchmark index of similar risk profile. Alpha basically conveys the amount by which active investors’ return beats or lags an index. For Indian markets, Sensex or Nifty are used as benchmarks and if the portfolio is up by nine per cent when the index gave a return of six percent, the alpha would be +3 and would be -2 if the portfolio return was only four per cent, underperforming the index.
Passive investors are mostly beta investors, where they are not looking to outperform the market and will accept returns that simply match the index of their choice. Beta is the degree of volatility and measures the risk arising from general market movements. A fund with a beta coefficient of one implies that it will mirror the market. A fund with a beta lower than one will be less volatile than the market; and higher beta implies more volatility than the benchmark index. Most investors would obviously love to outperform the market and gain higher returns every year. So, which strategy is better for investors? The answer lies in where you are investing. In developed and mature markets, due to high fees charged by active fund managers that eats into the returns of the investors, passive investing has been able to generate higher returns. This is corroborated by a recent study by S&P Dow Jones which showed that about 90 per cent of active stock managers failed to beat their index targets over the previous one-year, five-year and 10-year periods. Active fund management is a game of taking advantage of market inefficiency and information asymmetry.Developed and mature stock markets are more liquid and have advanced regulatory mechanisms, making them more efficient and giving active investors less scope for manoeuvrability.
According to a research by Moody, half of the US stock and bond market could be controlled by passive investors by 2021. Last year, flows into the US mutual funds and exchange-traded funds (ETF) reached a record $692 billion due to massive inflows into passive funds. On the other hand, actively-managed funds have faced steady net outflows over past years. On the contrary, emerging markets have certain idiosyncrasies that makes active investment more valuable.
Hima Bindu Kota