Active investing means picking up stocks based on a belief that your selections will give better returns than the overall market returns. Passive investing does not involve selection of individual stocks. It mimics particular select indices and is expected to give returns as per the indices, neither more nor less.

It has been a long running debate whether experts or fund managers can beat the market by active selection of stocks. The root of this debate lies in the efficient markets theory. Active managers believe that markets are inefficient. They believe that the anomalies in the market information can be found  by using techniques like fundamental analysis, technical analysis, quantitative analysis etc, which can help them arrive at a selection of stocks to beat the benchmark return. Passive managers believe that markets are perfectly efficient and that whatever information is available in the market is quickly reflected in the price of the stocks at any given point in time. In a perfectly efficient market there is no differential information available which can help one fund manager to make a better decision than another. As information becomes commoditized, markets become more and more efficient, thus making it more difficult for anyone to beat the benchmarks.

Instruments of Active and Passive Investing

Exchange traded funds (ETFs) and index funds are the two instruments used for passive investing. ETF’s are very popular in developed nations. In India too we have ETF’s but they are yet to catch on. We also have index funds which reflect the two major indices i.e. the SENSEX and the NIFTY and other benchmarks like the CNX 100 etc.

Most mutual funds schemes are actively managed. Then there are Portfolio Management Services (PMS) and private portfolios managed by advisors which fall under active management instruments.

Advantages and Disadvantages of Active Investing

Active managers have the flexibility to get in stocks or sectors they find attractive or get out the ones they find riskier. They also have the option to hedge their positions and use other things like call and put options to better their chances of beating the benchmark.

The disadvantage is that they may be grossly wrong at times. If they have a small basket of stocks and they go wrong in their choices, the returns may be very bad. To avoid this they may increase the number of stocks in the portfolio to an extent which might dilute the possible gains that can be made through active investing

A mutual fund manager is constantly and publicly judged for the performance of his fund at all points in time. He is expected to be ahead of the benchmark all the time. These factors often lead to most actively managed funds having a huge overlap in their top holdings in the portfolio to keep up with the peer group funds. It is far more acceptable to be wrong as a group than as an individual.

Advantages and Disadvantages of Passive Investing

The biggest plus points for passive investing are the low cost and high transparency. As the mandate is to mimic the benchmark, there is no need for heavy research expenses. Costs are also reduced as churning is low.

The biggest disadvantage is that the returns will never exceed the benchmark returns. So there might be times when there are fantastic returns in active funds, but passive funds will still be at benchmark returns.

Which Strategy is Better

An analysis of data for a three year return for Indian mutual funds shows that there were 75 schemes in the equity largecap space (Source: Value Research Online). This is where all the index funds fall in. The ranking for NIFTY funds within this space (based on 3 year returns) is between 14 to 61. That means out of 75 large cap schemes one NIFTY Fund stood at rank 14 and another stood at 61, and the rest somewhere in between interspersed with other actively managed large cap funds. The CAGR of these index funds was 18.15% (rank 14) and 15.92 (rank 61). So we see, that inspite of having the supposedly the same constitution there is a wide variation in the returns of the index funds. The difference arises due to two factors, the fund charges and the tracking error. Funds that charge higher will have lower returns. Tracking error arises from not having a portfolio that is a replica of the benchmark index. Hence the index fund return may be very different from the return of the index itself. This analysis also shows that there are actively managed funds that performed better and worse as compared to these the index funds.

Whether it is active or passive investing, most investors receive very different returns from what is shown in the statistics. The major reason for this is the behavioral biases that come into play. While it is common knowledge that you should buy low and sell high, in the real world the exact opposite happens. Money flees when the markets are falling and pours in when the markets rise. The liquidity in mutual funds becomes its bane at times. Since they are the easiest of the investments to redeem when need arises, they are the first ones to be out of the portfolio when an investor needs money. These few things impact the returns of the portfolio and in turn the wealth creation for most investors.

Most people look for the highest upside with a protection on the possible downside in investments. While passive indexing will give a protection on the downside as compared to active investing, it will never give very high returns. Active investing on the other hand can give high returns, but is extremely volatile and has unlimited downside potential.

In India, we still have majority of actively managed funds bettering the index funds. Going ahead as the Indian markets mature, it will be get difficult for fund managers to beat the benchmarks, as it has happened the world over. Till then a mix of active and passive strategy can work well for most investors combined with their individual risk profiling and goals.