26 Mar 2024
The debate over the pros and cons of active and passive investment management began decades ago and can still passionately divide the investment community but with the option to blend the two approaches, why argue for one or the other when you can have a foot in two camps and achieve the best of both worlds?
What’s the historical angle? The stock market crash of 1929 and Great Depression led to regulation that created the mutual fund structure we see today in the US, and so active management of funds began. Passive investing arrived in 1976 when John C. Bogle, the founder of the new investment company Vanguard, created the first index fund.
What’s the basic premise of these competing ideologies? In broad terms, active management involves selecting individual stocks with the aim of outperforming the underlying markets whereas a passive manager will try and track a specific market or index, buying into the efficient market theory.
What are the merits of active investing? Active managers aren’t required to hold specific stocks or bonds, they can use short sales, options, assessment tools and metrics to gauge equity market risk, interest rate risk, credit risk, and liquidity risk, insuring against losses, and they can exit specific holdings or market sectors when risks get too great. The ability to adjust to market conditions, and the opportunity for diversification creates the potential for higher returns. Active management has drawbacks such as generally higher fees (you need to pay research analysts and portfolio managers, as well as additional costs due to more frequent trading), difficulty in consistently outperforming the market, and the risk of human error.
What does passive investing offer? Most passive funds are operated automatically by an investment team rather than a fund manager, reducing running costs as no stock picking is needed. It is relatively clear which assets are in an index fund, so passive investing can also potentially offer greater transparency. Returns can be more predictable and for the S&P 500, the average annual return has been about 10% over long stretches. When markets are moving in a steady upward trajectory, the low-cost passive option is appealing as it bears fruit but can result in smaller, short-term returns when compared to active investing as it’s designed to provide returns that closely track the index rather than seek outperformance.
Passive equity funds have grown from 15% of investment fund assets in 2007 to 30% of total fund assets in 2017 in the EU. The popularity of passive investing continues to grow and at the end of 2023, the scales were tipped with more passive assets held under management than their actively managed counterparts. The rise of passive investing has led to some shifts in the active management arena when it comes to fees - the average expense ratio paid by investors in mutual funds roughly halved between 2000 and 2020 and is still on a downward trajectory.
Growth of passive investing has dominated markets over the last 15 years but there are elements of active investing that you simply can’t harness with a passive instrument. Market conditions affect returns and in more volatile times, opportunities for an active manager are there for the taking. With active investing, you have access to the full market, including less mainstream options such as smaller companies and alternatives and the potential to benefit from talented fund managers’ own styles and practices.
So why not combine the two? Mixing dynamically active and passive vehicles, depending on market trends and investors’ objectives, allows you to benefit from the advantages of both approaches. The most obvious starting point is to use the efficient market theory to follow large cap companies in the bigger, more mature markets such as the S&P 500 so that the trajectory of the wider market is captured. You can then complement this with select active funds introducing additional risk and return potential and offering diversification and protection in the event of market downturns, all at a cost that sits between the two management types.
You may have always favoured one investment style over another but blending active and passive strategies means you can seek outperformance while still being mindful of cost and tax efficiency. With the reduction in active management fees and the opportunity to harness the unique benefits of both strategies, some might say you’re missing a trick if you’re not considering a new blended approach.
Dominic Brooks, Business Development Manager
Katie Sykes, Client Engagement & Marketing Manager
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