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Personal investing

Active versus passive

As a proud advocate of a committed active manager, Thandi Ngwane does her best to stay objective in discussing the pros and cons of active and passive investment approaches.

Every asset manager has an investment philosophy – a stated approach to investing. To understand an investment philosophy, a good question to start with is to ask whether the asset manager is an ‘active' or ‘passive' investor.

Active managers study individual assets or groups of assets and make an active choice about which to own for their clients and which not to own – thus the word ‘active'. They think that the market sometimes misprices assets, such as shares, bonds and property, and that this creates opportunities to earn a return, for example to buy a share at a discount and then to sell it when it goes up in price.

If they are skilled enough over the long term to get more than half of these decisions right, and if they also put a bit more money in the winners than in the losers in their portfolios, they grow the savings of their clients by more than had they invested in 'the index' (a basket of investment instruments, e.g. shares, representing the overall market).

Active managers can do better or worse than the market depending on which individual shares or other investments they choose to own for their clients, and which they choose not to own. Not owning a share can have a positive outcome relative to the market, if that share loses value and drags down the overall market.

Passive managers, as their name implies, don't make any active choices about what to own and what to leave out of their clients' portfolios, they just buy a small amount of all the shares in the relevant stock-market index, normally in proportion to the market price of the company that that share represents. Since they don't try to make active choices, their philosophy implies that the price of shares is efficiently set by the share market, in other words, that the current price of each share is the best indicator of its long-term value.

Naturally, passive investors have no hope of beating the market, but they also are not in danger of doing much worse than the market. And passive managers have lower costs because they don't do research and therefore don't need to employ any investment analysts.

Which is better?

The prices of shares move when they are bought and sold. On each share trade there is a buyer and a seller, and, looking back, one of these will be right and one wrong. Because valuations are never certain, sometimes the lucky manager will be right. This is especially true over the short term when price movements are more random. Over the long term, when the business cycle has a chance to play through, more often it will be the manager with better skill who is right. Proponents of passive funds will argue that it is too difficult – maybe impossible – to tell who are the more skilled managers and who are less so. We disagree. As stock-picking skill is something that relies on the right people and processes and a lasting philosophy, and in good managers all of these are persistent, we think that skill is normally evident in long-term returns.

On the other hand, since they have lower costs and don't try to add value with research, passive managers should charge lower fees than their active counterparts. On an after-fees basis, the average passive investor will be guaranteed to do a little worse than the index, but not much. This may be a better result than trying to pick (and pay good money for) a mix of active managers who, on average, do not perform better than the index.

Whichever side you take, if there are too few active managers in a market, and thus not enough buying and selling of shares based on rigorous research, the market would get less and less efficiently priced and therefore worse at allocating investors' savings to companies with the best prospects. Without enough active managers, the average outcome for all active and passive investors, and indeed the outcome for society, would be worse. One could say that investors in passive funds are free-riding on those paying for the research in active strategies.

If you pick an active manager it is important to have confidence in the manager you choose, especially as managers who are likely to outperform the index over the long term, are also likely to underperform for periods of time. Managers who outperform also often invest in ways that are contrary to the popular opinions of the time, and their portfolios may be going down while the market is going up. This can cause anxiety for some investors. If you choose an active manager you need to stick with your choice during periods of underperformance so you can enjoy the returns when they come.

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