Index investing vs active management
Over the long-term, there are specific, well known active managers that have consistently outperformed both the market and their peers net of all fees. With the above in mind, and without undertaking a major statistical analysis reserved for PhD candidates, we examine some general, qualitative reasons why investors should consider active managers as part of their portfolios — especially in the context of the South African equity market.
Avoiding Concentration Risk One of the fundamental pillars of diligent long-term investing is that of diversification. This is however not always the case in the SA market. It is clear that any investment into one of these popular passive SA funds is taking on significant concentration risk without any analysis or justification other than the market capitalisation of these companies.
Investors also limit their investible universe and therefore lose the opportunity of investing in potentially stellar companies that may not form part of a particular index. It can be argued that most passively managed assets will eventually be controlled by a small portion of management companies.
This positive feedback loop may therefore drive a disproportionate share of passive investments into the hands of a few. This concentration of passive funds raises a few concerns: Common ownership of companies in the same industry can lessen competition among those companies in order to increase profits3. Few large institutions have considerable voting powers to best serve their needs. An isolated, yet significant idiosyncratic event at a large firm for example a cyber-security breach could trigger enormous redemptions from their funds, leading to destabilising market sales4.
The shift to passive investing may have also increased the systematic risk of stocks. This is suspected to be driven by index funds buying or selling the entire index simultaneously. The big risk here is that a market shock may have far broader impacts as stocks across the entire board are more closely correlated across various factors than ever before.
Downside Protection Equity markets go up and down in cycles, with the overall long-term trend being in the upwards direction. In bull markets, most equity strategies, whether active or passive, will see great returns and therefore satisfied investors. It is when times get tough however, and markets turn negative that active managers have an advantage. During these bear markets, index tracking funds have no ability to offer investors any downside protection. A situation that many SA investors are all too familiar with in recent times is that of large corporate fallouts.
The same active process can also be very rewarding during potential Black Swan events such as the COVID outbreak that is currently gripping global economies. Efficient Capital Allocation Buy low, sell high. This is the crux of any successful investment strategy. This therefore allows them to decide when is right to buy, hold and sell specific securities. Passive funds on the other hand are forced to buy stocks based on the index constituents.
Passive funds simply follow the index they use as their benchmark. Transparency: It's always clear which assets are in an index fund. Tax efficiency: Their buy-and-hold strategy doesn't typically result in a massive capital gains tax for the year. Passive Investing Disadvantages Proponents of active investing would say that passive strategies have these weaknesses: Too limited: Passive funds are limited to a specific index or predetermined set of investments with little to no variance; thus, investors are locked into those holdings, no matter what happens in the market.
Small returns: By definition, passive funds will pretty much never beat the market, even during times of turmoil, as their core holdings are locked in to track the market. Sometimes, a passive fund may beat the market by a little, but it will never post the big returns active managers crave unless the market itself booms.
Active managers, on the other hand, can bring bigger rewards see below , although those rewards come with greater risk as well. Active Investing Advantages Advantages to active investing, according to Wharton: Flexibility: Active managers aren't required to follow a specific index. They can buy those "diamond in the rough" stocks they believe they've found. Hedging : Active managers can also hedge their bets using various techniques such as short sales or put options , and they're able to exit specific stocks or sectors when the risks become too big.
Passive managers are stuck with the stocks the index they track holds, regardless of how they are performing. Tax management: Even though this strategy could trigger a capital gains tax, advisors can tailor tax management strategies to individual investors, such as by selling investments that are losing money to offset the taxes on the big winners.
Active Investing Disadvantages But active strategies have these shortcomings: Very expensive: The Investment Company Institute pegs the average expense ratio at 0. Fees are higher because all that active buying and selling triggers transaction costs, not to mention that you're paying the salaries of the analyst team researching equity picks.
All those fees over decades of investing can kill returns. Active risk: Active managers are free to buy any investment they think would bring high returns, which is great when the analysts are right but terrible when they're wrong. Special Considerations So which of these strategies makes investors more money? If we look at superficial performance results, passive investing works best for most investors.
Study after study over decades shows disappointing results for the active managers. Several other analyses report similar findings. Only a small percentage of actively-managed mutual funds ever do better than passive index funds. All this evidence that passive beats active investing may be oversimplifying something much more complex, however, because active and passive strategies are just two sides of the same coin. Both exist for a reason, and many pros blend these strategies. However, reports have suggested that during market upheavals, such as the end of , for example, actively managed Exchange-Traded Funds ETFs have performed relatively well.
While passive funds still dominate overall, due to lower fees, investors are showing that they're willing to put up with the higher fees in exchange for the expertise of an active manager to help guide them amid all the volatility or wild market price fluctuations. Active vs.
Passive Investing Example Many investment advisors believe the best strategy is a blend of active and passive styles, which can help minimize the wild swings in stock prices during volatile periods. Combining the two can further diversify a portfolio and actually help manage overall risk. Clients who have large cash positions may want to actively look for opportunities to invest in ETFs just after the market has pulled back.
For retirees who care most about income, these investors may actively choose specific stocks for dividend growth while still maintaining a buy-and-hold mentality. Dividends are cash payments from companies to investors as a reward for owning the stock.
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