Passive investment VS Active investment

 

Which method of investment is better, active or passive investment? The short answer to this is that passive investment has outperformed active investment in the last decade, but it may not be the case in the following years.

 

Passive investment involves selecting assets to try to outperform a benchmark via “passive” or “indexing” strategies that aim to replicate a benchmark. With the introduction and development of ETFs (Exchange-traded funds), passive investment has never been easier. Hence, investors have moved trillions of dollars in the past couple of decades from active to passive investment strategies.

 

The superiority of passive investing is evident in research. SPIVA, S&P Dow Jones Indices Versus Active which measures the performance of actively managed funds against their relevant S&P index benchmarks, in 2019 Active vs. Passive Scorecard, stated “a lack of persistence by active managers in beating their respective indexes remains omnipresent with the latest full-year scorecard. Most U.S. large-cap stock funds (90.46%) underperformed the S&P 500 over the past 15 years. At the same time, a majority of domestic small-cap core funds (92.35%) trailed the S&P SmallCap 600 Index. Outside of the U.S., S&P’s study lists more than 90% of foreign fund managers as failing to beat the S&P International 700 Index since the start of 2005.”

 

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As COVID-19 pandemic has wreaked havoc on financial market in 2020, however, the importance of active investment is now gaining momentum.

 

First, there will be clear winners and losers in post COVID-19 world. Investors will be have to pick not only sectors, but also companies within the same sector for winners and losers. Individual companies with stable cash flows and resilient business models to withstand a potential prolonged recession can outperform those companies that do not.

 

Second, in this volatile market, mispricing of stocks occur more often. Passive investments via benchmarking strategies will lose such opportunities to earn excess returns from temporary mispricing by the stock market as they invest in broad market or sector. Hence, active investors now have more incentives pick an individual stock to benefit from mispricing.

 

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Third, mega big companies outperformance is unlikely to continue indefinitely. The so-called FAMANG stocks (Facebook, Apple, Microsoft, Amazon, Netflix and Google) have risen so much that they now make up around 50% of the NASDAQ Index. Under such circumstance, passive investment has performed well as big names in the index continued to perform well.

 

However, the bull case for these big tech companies cannot stretch forever, as there are issues of over-valuation and regulatory risks (Facebook and Amazon, for example, on the issue of privacy and monopoly). Once they come to slow down on their stock appreciation, return on passive investors would have to decrease as well.

 

In the end, which investment strategies is better? No investment strategies is better than the other in absolute terms, as optimal investment strategies will depend on different market environment and different investor specific risk tolerance. However, post COVID-19 stock market might present a good opportunity for active investors seeking excess return.

 

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