Active Vs Passive? Which One is Best?

In the Investment Team at Astra we actively manage clients’ portfolios, rebalancing quarterly, and wherever it best serves the client; whilst taking a long-term view on those investment decisions. There has for many years been a circling debate surrounding whether to invest money in active investment strategies or to invest money in passive strategies. It is first helpful to set out how each of these investment approaches differ.

What is Active Investing?

To invest in active funds, is to invest in a fund manager whose aim is to ‘beat the market’ through objective and independent research into individual investments, thereby choosing those investments which look most appealing (in terms of returns). Each of these fund managers will measure their performance against a benchmark of their choice and will target beating said benchmark.

What is Passive Investing?

On the other hand, passive investing means to invest in a passive fund manager whose process doesn’t involve delving into specific investments, but rather invests in tracking an index of choice such as the S&P500. The aim of passive is simply to move and grow an investment in line with a specific index, not trying to outperform it.

Passive investing has gained much traction in recent years as more and more actively managed funds underperform passive benchmark strategies. However, this 12-month average returns outlook which takes into account benefits such as low fees and expenses is rather skewed when taking into account a longer-term outlook. When taking into account a longer-term outlook it is important to note that risk adjusted returns play a much more vital role in generating client returns. It has been shown active managers who focus on a fundamental value driven approach have actually produced larger risk-adjusted returns than index funds when measuring risk over longer time horizons. This is because, an index fund is not risk managed as it contains all of the risk of the index. For example, the FTSE100, rather than selecting certain segments of stocks from this index in accordance with a client’s risk profile. What comes as a result of this is a certain level of downside protection afforded to the client when investing in an index or passive fund.

The above table attempts to demonstrate the point of long-term time horizons in generating alpha (risk-adjusted return) through the use of active strategies of investment such as those employed at Astra. The table comes from a study which compares Morningstar’s US large cap value strategy consisting of 156 mutual funds which are actively managed, and the risk adjusted returns of the 52 funds in Morningstar’s large cap passively managed funds. For a short-time horizon of one month, actively managed funds show a negative alpha of 1% and passive funds of just less than half and percent. Both of these figures are on average equivalent of the fees and expenses incurred to invest in each of these strategies. When looking slightly further into the future however, we can see the alpha of active management strategies vastly improve to 0.5% for a two-year time horizon and just under 1% for a three-year time horizon; all the while index funds continue to produce negative alpha returns on investment. Overall this demonstrates the need for long term horizon investing, thus making the case for an active approach in managing portfolios.

The aforementioned comments all point towards that of taking long term approaches to investment decisions whilst investing in actively management strategies, in order to achieve strong returns. Where individuals can go wrong when doing this themselves is trying to be overly active in their management of investments; trying too hard to ‘time the market’. At Astra, although we are active managers in the sense that we are able to put money into strategies creating strong risk adjusted returns specific to client’s profiles, we do adopt a buy and hold strategy in regard to investment decisions. Another study conducted by Morningstar showed that average individual (retail) investor usually buys into funds that have had a stretch of good performance and then hastily sell on the cusp of less than expected returns (a fall in share price). According to the study, the badly timed buy and sell decisions consistent with the average investor in their efforts to seek returns actually hurt their portfolio performance on the whole.

At Astra we therefore conduct strong due diligence as to what investments will perform well choosing specific investments which will grow over a long time horizon choosing when to buy, and then hold on the investment with high conviction knowing that the decision of investments was through the lens of a multiyear time horizon. The greatest rewards reaped from investing in active strategies is likely to yield to those investors who are willing to take a longer-term approach to their portfolios, and to whom stand by their investment managers when markets are in volatile climates. Through these twists and turns active managers have been shown to prevail and outperform, and these comments are heralded by Morgan Stanley who found that active managers can be of greater use than passive managers during times of turmoil in markets.

Many investors and individuals have deeply divided opinions on this topic and my words above may not be enough to convince some of a pure active management strategy, however at Astra it is our view that active has at least a place in an investor’s portfolios. If you are of the strong opinion that fees and expenses are all that matter when choosing where to invest money, then investing solely in passive strategies and index funds may be your first port of call. From our perspective, investors lean more towards placing a higher emphasis on liquidity, returns and risk of their portfolios looking beyond fees. Nonetheless it all boils down to personal preference in terms of your investment time horizon and why your investing.