Active and passive investments: We tell you the good and the bad

Pranati Deva
Updated: 13 Dec 2021, 05:09 PM IST
TL;DR.

Investors keep debating the merits and demerits of active versus passive investing. Let's look separately at both these investment strategies to identify which one fits you better.

Understanding the difference between active and passive investment strategies

Understanding the difference between active and passive investment strategies

Both active and passive investment have been popular strategies among investors with different risk appetites and portfolios. There has been a large number of discussions as to which one should be favored. Let's take a look at each of these strategies and their advantages and disadvantages to help you decide better which one suits you.

Active investing is a very hands-on approach to investing, as suggested by the name. It requires an investor or a portfolio manager who takes full advantage of near-term volatility or share market fluctuations to derive a profit. The main aim here is to beat the stock market return and is preferred more by investors with a deep knowledge of the stock market. Better analysis of stocks, bonds or other instruments is needed to properly utilise this strategy.

And requires that someone act in the role of a portfolio manager. The goal of active money management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations. It involves a much deeper analysis and the expertise to know when to pivot into or out of a particular stock, bond, or any asset.

Meanwhile, passive investment is the complete opposite. In that strategy, investors limit the sale and purchase of stocks, bonds, etc within their portfolio and invest for the long term. Instead of taking advantage of market volatility, they ride it out with minimal changes to their portfolio unless absolutely required. They do not react to each and every market move but have a more buy and hold approach with the main aim of generating robust returns in the long term. It is a more cost-effective way of investing in comparison to active investment.

One of the main examples of passive investment is index funds that follow major indices like Nifty, Sensex. In this, when the index replaces a stock, the investor does not have to individually buy or sell, the fund automatically makes the changes.

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Things to know about active and passive investments

Let's now take a look at the pros and cons of each investment strategy:

Active investing

Pros

A major advantage of active investment is that it gives flexibility to your portfolio manager to go after alpha-generating opportunities in the market. You can profit from short-term market volatility, book profits as and when needed, modify and rebalance portfolios more frequently and cut losses early. The fund manager has the authority to make quick decisions and act as to the market situation. Chasing such opportunities can also give you a better growth potential and achieve stellar returns even in the short term.

Cons

One of the biggest drawbacks of this strategy is that it is very expensive. The expense ratio of an actively managed fund is way higher than that of a passive managed one. Also, there are other costs like research analysts, fund managers. Since you are constantly selling as well, there may also be exit load applied as well as the capital gain tax is higher in this case. Often such investment is due to such high expenses. Passive investing often outperforms active due to its lower charges

Another major disadvantage is the risk factor. Active investors must have a very high-risk appetite since while the volatility in the stock markets can make money it could just as easily lead to losses.

Passive investing

Pro

The main advantage of passive investing is that it is way cheaper than the active one. The expense ratio for such funds is minimum. It also saves on capital gains tax since long-term investments attract lesser rates and the rate of selling is also lower in this kind of investment.

Another advantage is transparency. The funds generally chosen by passive investors are very transparent and any change in the portfolio is communicated clearly to the investors.

Cons

The major drawback is that choices are very limited. Passive investment also does not offer the same flexibility as the active one. Despite the market condition, the investor is stuck with the fund. In case the investor withdraws, he would be selling units of the overall fund, portions that underperformed as well as outperform.

Also, passive funds do not generally beat the market returns. it cannot give the returns that an active investor is looking for. These funds are cheaper but the returns are also marginally lower.

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Active vs passive investments

However, it is important to note that even though both styles of investing have advantages and disadvantages, passive investments are generally more popular than active investments. Historically, passive investments have also given better returns than active investments mainly due to lower expenses. However, active investment is more preferred during times of market volatility.

Deciding on whether to choose an active investment strategy or a passive one completely depends on the investor and the portfolio he is looking for. It also doesn't have to be one way or the other, an investor can also look for a strategy that combines the two.

First Published: 13 Dec 2021, 05:09 PM IST
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