Active vs passive – why debate?

The active versus passive investment strategies debate has been raging for many years, with both sides trying to make a case for their own strategy at the expense of the other.

Without pre-empting our own beliefs on this matter, we will start with the words of US author John C Maxwell: “A great idea is simply the combination of many good ideas.”

Before one can start the conversation one must first look at the key characteristics of both strategies.

Passive

A passively-managed investment strategy is one where the investment manager pools large sums of investor money to buy assets in accordance with the constituents and weightings of a chosen index.

The manager will therefore make no active decisions regarding which benchmark assets to include in or exclude from the portfolio, nor will they change the benchmark weighting assigned to the given asset.

Active

In contrast, an active investment manager will decide which benchmark assets to include in the portfolio, and will typically deviate from the benchmark weightings.

An active manager will also typically hold fewer assets than the benchmark, making the portfolio more concentrated than the comparable passive portfolio.

This gives the active manager the opportunity to outperform the benchmark.

Pros and cons

Both strategies have strengths and weaknesses.

For example, passive strategies are usually cheaper than actively-managed portfolios but are limited to the benchmark they track, whereas active managers have the flexibility to invest in the specific assets that are expected to deliver index-beating returns.

Tax is another topic of debate. Passive investors argue that the buy-and-hold strategy gives them the upper hand via pre-tax compounding returns, whereas active managers can manage taxes for the investor – offsetting taxes on gains in a year where the investor has realised other losses.

The decision of whether to use active or passive investment strategies usually comes down to investor preference.

A third option …

But could a ‘great’ investment solution not simply be a combination of two ‘good’ investment strategies?

We believe there is a place for both active and passive investments, and instead of choosing a single strategy, one can combine these two strategies to create a solution that will benefit the individual client.

An investment manager can, for example:

• Allocate a portion of a client’s portfolio to a passive investment, which will give the client beta/index returns; and
• Use the remainder of the portfolio to make active decisions and only allocate capital to high-conviction ideas.

The result is a cost-effective portfolio that can achieve alpha/excess returns over time.

This strategy is commonly referred to as a ‘core-satellite approach’ to portfolio construction.

Listen/read: Passive and active investing can work well together

The core-satellite example is but one of many ways that investment managers can use both active and passive investment strategies to build and optimise investment solutions.

We believe it is therefore fruitless to debate which investment strategy is superior.

In the end, it all comes down to the needs of the client and the skill of the investment manager to use all of the tools at their disposal.

Listen to Ryk van Niekerk’s Be a Better Investor interview with ETF strategist and advisor Nerina Visser (or read the transcript here):

You can also listen to this podcast on iono.fm here.

Dr Francois Stofberg is senior economist and managing director of Efficient Private Clients.