The difference between active and passive investing

Active and passive investing are types of investing strategies. While there are differences in the two approaches, there are also some similarities. In the sixth episode of season one of the Unpacking Wealth Creation podcast series, Lisa Stride and Fabrice Muhizi, both investment managers at Investec Wealth & Investment, discuss this important topic.

What do active and passive investing entail?

“In both approaches, a decision has to be made but it’s how often you have to make the decision that determines whether a strategy is active or passive," explains Stride. "Active investing is much more hands-on than passive and involves handing the reins to a team of research analysts and portfolio managers, who construct the final portfolio and reposition its exposures as necessary given the prevailing market environment. The objective of an active strategy is to achieve ‘alpha’ – in other words, to beat the market benchmark.

“A passive strategy is more of a buy-and-hold strategy. You have to decide yourself when and how to reposition your exposure, whereas with active investing, it is done for you by the fund manager.” 

Muhizi adds: “Fundamental to the whole idea of active investing is the premise that markets are not perfectly priced. The fund manager’s job is to identify the mispricing and position themselves accordingly to beat the market – or create alpha. This involves conducting fundamental analysis to really understand the investments we’re making and their prospects, so that we can get the best outcome for our clients as possible. 

“Active management, by definition, is holistic. So, we’re looking at valuation, we’re looking at the quality of managers, we’re looking at how these managers’ decisions affect the environment and the communities in which they serve. This requires a lot of resources - we’ve got teams of analysts doing in-depth due diligence which gives us comfort that we’re making the right investments.”

Does passive investing make sense in South Africa?

“The problem with passive investing in South Africa is that we’re a small market in the global context so you potentially expose yourself to less diversification and more concentration risk than if you picked a more global index," says Stride.

“For example, the top 40 stocks make up 60-65% of the Johannesburg Stock Exchange (JSE). This is huge compared to the S&P 500 in the US where the mega tech stocks make up 20%. So, you can see the difference in concentration you achieve when selecting the JSE Top 40 versus the S&P 500. 

“There’s also pricing. SA passives tend to be a lot more expensive than the offshore options although this may change in time as the SA market develops."

Is passive investing cheaper than active?

“The fees charged by active managers are generally higher than those you’d pay for a passive strategy," says Stride. "However, remember that active fees are in place to pay the research and portfolio management team, so that they’re committed to making the best decisions for you in the face of a constantly changing market environment.”

“Active investing is associated with higher implementation costs, and some managers struggle to generate the returns to overcome this hurdle," explains Muhizi. "But remember that with passive investing, you can never beat the market because your return is what the market returns, minus some fees. You’ve got to back your active manager to be better than average and if they beat the market, then the fees are justified.”

What type of investor are you?

“It’s important for investors to decide upfront what type of investor they are,"" says Stride. “Considering your investment sophistication and the time you’ve got to dedicate to your investments, are you able to choose the right investment option for yourself? Are you happy to simply sit back and own the market? Or do you want something a bit more that can be designed according to your individual risk and return profile? If you marry quality financial advice and quality actively managed solutions, I believe you get far down the road in appropriately structuring your long-term financial objectives.”

Why is active investing important now?

“Now, more than ever, you’re really getting value for money from an active investor who’s generating alpha," says Muhizi. "The dispersion of outcomes is so wide while markets are highly volatile so simply being in the market could land up being very negative for you. Using fundamental analysis can increase the probability of better outcomes. The reality is that, to have any chance of beating the market, you have to be an active investor. It’s that simple.”