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When is the right time to shift from active investing to passive investing?

05 Jan 2023

Active investing is a very broad term. It is all about taking a view on the markets and then taking a view on the stocks and buying stocks accordingly. The whole idea of active investing is that with the help of in-depth research you identify solid stocks that can not only create wealth in the long run but also help you beat the market by a margin. Typically, in active investing you combine stock selection and market timing to outperform the market. What do we understand by active investing vs. passive investing? You also need to know when to shift from active to passive management. The shift to passive investing can be an important decision in enhancing your returns.

So, what is passive investing all about, and does it make sense in India?
Passive investing is a slightly different ball game. It is based on the premise that it is impossible to beat the market consistently. Hence it makes more sense to just track the index over a period of time and get market returns. So buying an index fund or buying an index ETF are all examples of passive investing. Obviously, active investing does work or there would not be so many active fund managers in the world. Also, there would not be so many funds that consistently beat the market. The key argument in passive investing is that while there are some managers who will outperform on some occasions and some who will outperform on other occasions, it is impossible for an investor to know who will outperform and when. That is the reason passive investing makes a case for index investing. Don’t forget that the Sensex has multiplied 360 times since its inception in 1979 while the Nifty has appreciated 11 times since its inception in 1995. Surely, there has to be some merit in passive investing.

The big question: When to use passive investing..
Instead of looking at active investing and passive investing as two alternative approaches, the better method will be to use active investing in times when it makes more sense and shift to passive investing when that makes more sense. So how do you figure out when is the time to shift out of active investing and shift into passive investing. Here are 7 key triggers to make the decision..

Back in 2007 about 20% of all assets under management (AUM) in the US were under passive investing. By 2017 that share increased to 33% of the total AUM. There is surely a little more than chance at play. In the last 10 years fund managers, especially active hedge fund managers, have been finding it extremely difficult to beat the markets. When you find that the ratio of fund managers beating the index is falling, it is a signal to shift to passive investing.

When markets are being driven by macros rather than by micros. An active market is basically a stock selection market and that is possible only when the micros trump the macros. Between 2008 and 2013, we saw most of the central banks across the world follow similar monetary policies. Hence most markets were being driven by global systemic factors and passive funds were actually outperforming active funds. That is a case for passive shift.

When valuations are above the historical average of the market. That is again a phenomenon we get to see quite often in the Indian market. How much higher than average is a matter of judgement and you must take the view based on the projected earnings growth. If the valuations are well above the historically average P/E and there is limited earnings visibility, then again it is a case for passive investing over active investing.

When the spread between active funds and passive funds is consistently narrowing. Remember, active funds take on unsystematic risk in the market which passive funds don’t. That means for investing in an active fund you better be compensated with relatively higher returns. If that spread is consistently narrowing then it means that active fund managers are increasingly finding it difficult to identify and play on alpha. That is again a clear indication for you to go ahead and shift to passive funds.

Look at the fees differential between active and passive investing. As an active investor you wanted to compensate for the higher fees that you pay and also for the higher risk that you take. Fees are a very important component of your total returns. Remember, when you shift to passive investing like in the case of index funds you save big time on fees over a period of time. It is estimated by Bloomberg that Vanguard, which is a pioneer in index funds, has saved close to $1 trillion for investors purely through lower fees. That explains why the two biggest fund houses in the world today (Blackrock and Vanguard) are passive funds.

A study in the US in 2016 showed that 90% of the active fund managers had failed to outperform the index over the last 1 year, 5 years and 10 years. There is surely merit in passive investing. You will be better off if you know when to shift to a passive approach to investing.

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