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Understanding the difference between active and passive investing

05 Jan 2023

Asked about the difference between an active investors and a passive investor, a student of finance interpreted it as the difference between Warren Buffett and John Bogle. While that may be an oversimplification, the answer is as close to the truth as possible. Warren Buffett is the ultimate example of the active investor. He believes in identifying quality stocks with deep value and holding them to eternity (well almost). The focus of Warren Buffet has always been on finding stocks with a solid margin of safety quoting at discounts to their fair value. His company, Berkshire Hathaway, has been one of the greatest wealth creators in the history of active investing.

John Bogle, founder of Vanguard Funds, is the father of passive investing in the world. Ironically, in the latest annual report of Berkshire Hathaway, Buffett personally lauded the contribution of John Bogle and his Vanguard Funds in creating wealth for investors at a very low cost. The Vanguard principle is that it is impossible to beat the markets consistently and therefore it makes more sense to put the money consistently in passive funds for a very long period of time. Basically, you can become a passive investor by buying index funds or index ETFs. Since passive funds do not employ high-cost fund managers to beat the market, the lower costs are passed on to the investors. It is estimated that the Vanguard funds have already saved nearly $700 billion for investors in the form of lower costs since its inception!

What are the pros and cons of active investing?
The first big advantage of active investment is that it gives flexibility to the fund manager to chase opportunities and alpha in the market. The fund managers also have the leeway to hedge their open positions in the market, modify their investment mix, focus on assets that look promising etc. Active investing can also be a good means of tax management. Selling off investments that are making losses and writing off these losses against profits can be a very tax-efficient method of improving your post-tax returns.
But active strategies also have some important downsides. Firstly, they offer a high cost approach. Managing the marketing, administration and the high cost human resources adds quite a bit of burden on the end investors. The problem is that, more often than not, active managers are not able to outperform the index after considering the related costs. That actually reduces the attractiveness of active investing for investors. The second risk is that most fund managers may end up buying risk rather than reducing risk, which should be the core function of a fund manager.

What are the pros and cons of passive investing?
As Buffett himself acknowledged, the big advantage that passive investing has brought to investors is a low cost approach to creating wealth over the long run. Passive investing typically works over the long run and hence, by default, it instils a long term perspective in investors. This has normally worked in favour of small investors in the long run. Since passive investors are typically into indices, there is absolute transparency on the portfolio strategy of the index fund. There is little by way of surprises in terms of asset exposure and that is positive for investors.
The downside is that the choice is quite limited in a country like India. In countries like the US and other Western countries there is still a wide choice available to investors in terms of passive fund offerings. In India if you look at index funds and index ETFs as a proportion of total funds available, it is quite miniscule. This largely limits the choice available for small and medium sized investors.

How to make a choice: Active versus Passive Funds:
There are 3 basic considerations which will drive your choice of active versus passive investment. You can use these criteria to take a final call on whether you should opt for a passive approach or an active approach.

Is the market offering alpha opportunities or is it more of a macro play. If you are investing in India because you believe that India is a great opportunity, then an index fund or a passive fund can do the job for you. You can achieve your goal through a low-cost and low-risk strategy and yet get above average returns. In case of macro plays, prefer a passive fund.

Are we in a matured market in terms of valuations or in a market that is still offering tremendous stock specific opportunities? The US and Europe are examples of the former while India is an example of the latter. That explains why passive funds have picked up so much steam in developed countries but it is still at a nascent stage in countries like India.

If you are looking at safety and diversification then a passive approach will work better. Both these are achieved better in case of passive investing than through active investing. Passive funds are less risky compared to active funds since the human bias is largely eliminated.

At the end of the day, your choice between active and passive need not be (either/or). You should ideally look at a portfolio that combines allocation to active and passive assets. That could be a mid-way!

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