The Difference Between “Active” and “Passive” Investment Strategies

Investing is difficult to do well, and that is partly because as human beings we are not really as rational as we like to think. So choosing a good investment strategy and sticking to it are important keys to doing well from any investment strategy. Try to ignore the emotional angles in other words.

That means that for many investors using managed funds that provide the diversification across many different investment sectors and economies become a pretty good choice: they get the spread across a lot of markets and reduce their risk, and because it is separate to other accounts that investors and savers have there is a tendency to not look at them quite so often – hence avoiding making emotional decisions a lot of the time.

But within managed funds there are generally 2 kinds of investment strategy - active or passive.

What Is a "Passive Investment" Strategy?

A passive investment strategy is one that doesn't try to pick specific assets, like Fletchers shares or U.S. government bonds to invest in. Instead they invest in all the available assets in a given market. For example, a fund passively investing in Japanese equities would buy all the shares listed on the Japanese stock exchange.

The fund will allocate its money between the different specific assets (eg different shares in the market) depending on the total market value of the asset relative to the market as a whole. For example if Fletchers shares are worth 5% of the total value of the shares available in the NZ sharemarket, then a passive strategy would mean spending exactly 5% of your fund on Fletchers shares. This means that as the value of assets change in the various market segments the passive fund will need to be rebalanced so that it still reflects the market.

Using a passive strategy means that you will get the (weighted) average return on all the assets in the market. Having such a well-diversified strategy should also reduce the variability of your returns compared to investing in only a few assets.

How an "Active Investment" Strategy Differs

Active investment strategies are the opposite of passive ones. With an active strategy the fund manager tries to do better than the average return on the whole market by "picking winners". The fund manager will have ideas about which assets are undervalued or overvalued or have some other plan of how to beat the market as a whole.

Active investment funds are usually more expensive than passive ones as they take more research time, and there will also be extra costs if they buy and sell shares more often than passive funds.
Passive funds will give you a return on your investment (roughly) equal to the return on the whole market for their kind of investments (in other words for the "asset class").

However, by definition the average return on all the actively managed funds and private investors must also be equal to the return on the whole market. That means if some investors do better than average, others must do worse than average.

The key for an investor in choosing the right strategy for them is deciding on whether they believe someone can do better than the market as a whole, so the two questions to ask are:

1. Are there active managers out there who can regularly beat the market with a better than fluke record?
2. 2. If so, can I reliably find out who they are?

If you answer yes to both of those then invest in those active funds you've found. Otherwise you'd probably be better off with passive funds - after all you don't want to pay more for something if you don't think you'll see any benefit.

At Bay Financial Partners we believe we know the answers to both those questions.. Give us a call on 07 578 3863 and make an appointment to see which funds active or passive that might suit your needs.