05) Exchange-Traded Funds: Active Vs. Passive Investing

by · October 16, 2010

Exchange-Traded Funds usually take on a passive approach to investing. Lately, there have been ETFs with a more aggressive or active stance on investing. Which approach is better for an investor?

What is Active Investing?

Active investing, simply put, is attempting to outperform the market. Its goal is to beat a particular benchmark. This is currently the more dominant approach towards investing. Mutual funds are examples of actively managed investments.

There are many strategies employed in active investing or active management. These can include technical analysis, quantitative analysis, fundamental analysis, and macroeconomic analysis. Active managers are constantly searching for information to help them with their decisions and guide them through with their ideas. The active manager is always after that anomaly or irregularity in the market that can be exploited in order to make a profit.

One of the main advantages of active management is the the chance of outperforming the market due to superior skills and experience. Their decisions, knowledge of the market, and ability to identify opportunities all come together to contribute to a superior performance. Even if the market is performing badly and there is a sign of recession, active managers can take measures such as hedging to reduce the impact on their portfolios.

The disadvantage of active investing is that it has a higher operations overhead. The higher fees can be a serious detriment for a manager to outperform the market in the long run. To counter this, their portfolios have fewer, more concentrated securities. However, this strategy can be dangerous in that a small mistake can have a larger impact, potentially causing the portfolio to under-perform the market significantly.

What is Passive Investing?

Indexing is considered a passive approach as it does not actively seek information on which to base its decisions on investments. Instead, passive management aims to use the same methods of building a portfolio as the index it follows. For example, a passive manager will invest in the exact same securities with the same proportions of indexes such as the S&P 500. Its goal is to duplicate the performance of the index as much as possible. Passive managers invest in broad market sectors that are also known as asset classes.

Passive investors follow the EMH or Efficient Market Hypothesis. This idea revolves on the premise that the market prices are continually fair and reflective of information. Therefore, beating the market is hard and is not an option. It will only try to match the market performance as closely as it can, as opposed to beating it.

An advantage of passive management is directly opposite to that of the active approach, which means lower costs of investing. Decision-making by the manager is also at a minimum. The only goal of this approach is to closely match the performance of the index as much as possible.

The obvious disadvantage is that the investment will never be able to outperform the index it is following. Since performance is based on the underlying index, managers are almost helpless when the overall market is on a downward trend.

The Best Approach
The debate as to which approach is superior goes on without a clear winner. Banks, Wall Street firms, and insurance companies are among the few who take on the side of active investing. On the other side are the  research centers that are funded privately and the researchers from national universities to name a few.

Each side has their own strong points. But with their different ideologies, it is somewhat difficult to compare the two directly. For certain each investing approach has its own advantages and disadvantages.