Active vs Passive Investing

One of the biggest distinctions in investment management styles has to do with active investment management versus passive investment management. Active investing is a more hands-on approach to investing that generally involves research to attempt to find investments that can ‘beat the market’. Some investors will indeed outperform the market, but many investors will underperform the market. Passive investing is more hands-off. It attempts to essentially ‘track the market’ without trying to outsmart it. That involves less research, less trading, and less maintenance than with active investing. Passive investing is sometimes synonymous with ‘index investing’.

If you’ve spent any time online learning about investing, you’ll know that the merits of active versus passive investing can be a heated debate. And while many discussions frame the decision to use an active or passive investment approach as a binary choice investors have to make when determining how their investments are managed, the reality is that many investors incorporate both styles into their overall portfolio management. In this article we’ll explain what each style is, how they are used, what considerations you need to make when determining which style, and how much of each style, might be appropriate for your own situation.

What is Active Investing?

For now, let’s just consider one market: the Canadian stock market. The main indicator associated with the Canadian stock market is the S&P/TSX Composite Index. When people ask how Canadian stocks have performed, they reference the S&P/TSX Composite Index’s performance. An active investor buying Canadian stocks would judge their portfolio’s performance against this broad index. Assuming the same levels of volatility in the index and the investor’s portfolio, if the index was up 10% and the investor’s portfolio of Canadian stocks was up 12% they would have outperformed. Conversely, if the investor’s portfolio was up 5% then they would have underperformed the index.

In order to ‘beat the market’ the active investor can employ a variety of strategies. They may choose to only invest in a handful of companies, they may gamble on penny stocks or meme stocks, they may trade the same stocks in and out of their portfolio on a regular basis, they may choose to try and time the market by only being invested during up-swings and trying to avoid the downswings, and so on. These are just a few examples of active investment strategies.

Note that the judgement of outperformance may not simply be the relative change in value of an investor’s portfolio versus the index. An active investor would look at the risk-adjusted performance difference. In other words, if the index was up 10%, but the investor was up 8% while experiencing half of the volatility of the index, then on a risk-adjusted basis they might have achieved their goal of outperformance. Similarly, if the index was up 10% but the active investor was up 11% but with twice the volatility in their portfolio, they may have underperformed on a risk-adjusted basis.

Active investors can execute active strategies themselves, or they can hire someone else to actively manage their money on their behalf.

Here are a few examples of active investing:

• A mutual fund manager picking stocks and bonds to buy and sell for a fund
• A hedge fund manager using leverage and short selling strategies
• An individual investor researching and picking individual stocks to buy and hold
• An individual investor trading in and out of index ETFs, or using index ETFs to time the market

Some investors choose active investing strategies for emotional or entertainment reasons. It can be more engaging and can provide a sense of control and satisfaction for investors who enjoy the process of researching and picking individual securities.

However, there are also disadvantages to active investing. For one, active investors can have higher tax-drag in non-registered accounts as they tend to have higher turnover rates (more buying and selling activity). Additionally, there is a risk of underperforming the market, and active investing can be time-consuming to research and monitor investments, as well as more emotionally demanding. Active management also tends to cost more in fees and expenses due to higher trading activity than passive management. If you are using a fund manager, you’ll additionally have to factor in the costs the fund charges (MER, or Management Expense Ratio).

What is Passive Investing?

Passive investing is synonymous with buying and holding a portfolio designed to track the performance of a particular market index, which is more commonly known as index investing. However, some people consider passive investing to be any strategy that is low maintenance with low turnover like someone who buys a portfolio of 25 stocks and never touches them again for 40 years. For the purposes of our discussion, we will focus on passively managed index investing.

Using our example of the Canadian stock market, someone using a passive investment strategy for Canadian stocks would simply just buy an index Exchange-Traded Fund (ETF) or index mutual fund that tracks the S&P/TSX Composite Index. Because index funds don’t have to perform extensive research on company financials and market dynamics and just need to copy the proportional holdings of the index they are tracking, they don’t tend to cost much to run. In fact, one of the ways that different index fund providers compete is on having the lowest costs. While an actively managed investment fund for Canadian stocks might cost between 1% to 2% per year, a passively managed index fund for Canadian stocks might cost 0.1% per year. Additionally, index funds don’t trade their holdings on a regular basis because the index is relatively static over long periods of time. Trading costs are lower and as an added benefit of low turnover, they can be more tax efficient.

One of the main reasons some investors are attracted to passive investment management is the combination of low costs and low maintenance. Passive investors are also trading off the chance of outperformance against the possibility of large underperformance against the index. They are happy to earn the index return, less the generally low costs of passive investment management. Note, however, that this holds true in both up and down markets. If the index is down 10%, then the passive investor will be down 10%, plus or minus the tracking error, and less costs. Tracking error is the difference between the performance of the fund versus the performance of the index. While index funds attempt to exactly track the performance of an index, in practice they can outperform or underperform by very small amounts.

Passive investing should not be confused with low-risk investing. The risk levels of a portfolio are going to largely be determined by asset allocation.

So far, we’ve been using one market for our examples but active and passive investment management styles can be applied in all markets such as fixed income, commodities, real estate as well as across geographic boundaries. Let’s now take a look at some practical applications of active and passive investment and how they can be incorporated into a portfolio.

How to incorporate active or passive investment management into a portfolio

A prudently constructed portfolio is important for long-term investing success, and involves incorporating an individual's goals, risk tolerance, risk capacity, need for risk, and time horizon. Let’s look at a basic 60/40 portfolio, which is a popular asset allocation strategy, and involves investing 60% of assets in equities and 40% in bonds. This strategy aims to provide a balance between growth and stability over the long-term, with the equities portion providing potential for higher returns, and the bonds portion providing a buffer against market downturns. Note that because 2022 was a poor year for both equities and fixed income with fixed income performing even worse than many equity markets, a traditional 60/40 portfolio fared poorly last year. But with long-term investing it’s important to focus on just that: the long-term. No strategy will be the best performer in any given year, and positive and negative surprises are common. While 2022 didn’t see fixed income playing its traditional role of being a buffer for portfolios for that one year, over long periods of time it has been a good complement to equities for investors seeking a balance between growth and stability.

For an active investor looking to build a 60/40 portfolio, they might pick individual stocks and bonds. For example, an active investor might choose to invest in a mix of growth and value stocks, as well as high-yield and investment-grade bonds. Additionally, an active investor might also choose to invest in foreign stocks and bonds to add diversification to their portfolio. But they might find that while they are interested in stocks, they are not as comfortable picking bonds. They could pick individual stocks for 60% of their portfolio and perhaps buy a fixed income mutual fund that is actively managed for the remaining 40%. 

On the other hand, a passive investor might choose to implement a 60/40 portfolio using index funds or ETFs. For example, a passive investor might choose to invest in two equity index funds, one that tracks the S&P/TSX Composite Index and one that tracks the S&P 500 for the equity portion of the portfolio, and then an index fund that tracks the performance of a bond index for the bond portion.

Using both active and passive management in a portfolio

A hybrid approach, which incorporates elements of both passive and active investing, can also be used to implement a 60/40 portfolio (or any other asset allocation). For example, an investor might choose to use index funds for 80% of their equities to keep overall costs low, but still want to pick a few individual stocks with the remaining 20% portion of their equity allocation and choose to index all of their 40% fixed income allocation. Overall, they still have a 60/40 portfolio but it incorporates both passive and active management styles.

Another example of a hybrid approach that is common is for investors to individually pick stocks from US and Canadian markets (markets that they are more familiar with), but to use index ETFs for stocks from other developed and emerging markets with which they are not as familiar but want the geographic diversification they bring to their portfolio. In this case, their equity allocation is split between active and passive management. For the remaining fixed income allocation, they might use one ETF that tracks a portfolio of globally diversified fixed income indexes.

Conclusion

In conclusion, both passive and active investing have their own advantages and disadvantages. Passive, index investing is a low-cost, low-maintenance strategy that aims to match the returns of markets, while active investing is a more hands-on approach that involves picking individual stocks, bonds, or other securities with the goal of outperforming the market. A well-balanced portfolio is important for long-term success and investors can choose to use either active or passive investment strategies or a hybrid approach that incorporates elements of both. It's important for investors to understand their own risk tolerance, time horizon, and goals and make a decision that aligns with those factors. With the right approach and a long-term perspective, investors can achieve their financial goals regardless of whether they choose to be passive, active, or a combination of both.