Active or Passive Investing

Whilst asset allocation is the main contributor to the performance of a portfolio, our investment philosophy also adds value to the investment process. Our investment recommendations to our clients will always reflect our investment philosophy and so it is important that this be fully explained.

There are two main schools of thought; one that outperformance can only come from Active Management and one that believes that driving cost out of the portfolio will generate better returns over the medium to long term.

Passive investing is a style of management where a fund’s performance aims to mirror a market index. Followers of passive management believe in the “efficient market hypothesis” which states that at all times markets incorporate and reflect all information, rendering individual stock picking futile.

Passive management is the opposite of active management, in which a fund manager attempts to beat the market with various investing strategies. Active stock pickers believe that the market is not completely efficient and that it is possible to add value for their clients by exploiting pricing anomalies.

The objective with active management is to produce better returns than those of passively managed index funds. For example, an active fund manager focusing on large capitalisation UK companies would look to beat the performance of the FTSE 100 index whilst a passive index tracker would look to replicate the performance of the index.

Are markets efficient?

Although it is a cornerstone of modern financial theory, the efficient market hypothesis (EMH) is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis.

While academics point to a large body of evidence in support of EMH, there are also plenty of notable dissenters. For example, investors such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. Detractors of the EMH also point to events such as the 1987 stock market crash, when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values.

Advantages of passive investing:

Disadvantages of passive investing:

Advantages of active investing:

Disadvantages of active investing:

Based on the above and our other research we believe that any decision to invest into passive or active funds (or a combination of both) should be made after full consideration of your financial goals and resources, risk tolerance and time horizon to invest.