PASSIVE VS ACTIVE INVESTING: WHAT YOU NEED TO KNOW

Costs and Fees Comparison

One of the most significant distinctions between passive and active investment strategies lies in the associated costs. Understanding how these costs affect long-term portfolio performance is crucial for investors seeking to maximise returns.

Passive investing fees

Passive investment strategies, such as index fund investing or exchange-traded funds (ETFs), aim to replicate the performance of a market index like the S&P 500 or the FTSE 100. Because these funds do not require constant portfolio management, trading, or deep research, they typically come with much lower fees. Management expense ratios (MERs) for passive funds often fall below 0.20%, with some ETFs offering fees as low as 0.03% annually.

In addition to lower MERs, passive investors also benefit from reduced trading costs. Since passive funds only adjust their portfolios in response to index changes, fewer trades mean lower transaction fees and minimal tax implications in taxable accounts.

Active investing fees

By contrast, active investing involves fund managers making continual decisions to buy or sell securities in an effort to outperform the market. This intensive management means higher operational costs, higher turnover, and increased trading expenses. Active mutual funds commonly charge MERs ranging from 0.75% to 1.50%, with some reaching even higher levels.

These higher fees mean that active funds need to generate surplus returns just to break even with passive alternatives. Moreover, higher fund turnover often triggers capital gains, which can result in additional tax liabilities for investors not using tax-advantaged accounts.

Cost impact on returns

Over time, these cost differences compound significantly. Consider an example: an investor contributes £10,000 annually for 30 years to either a passive fund with a 0.10% fee or an active one with a 1.00% fee. Assuming a gross return of 7%, the passive investor ends up with roughly £944,000, while the active investor nets about £788,000. That’s a difference of over £150,000 solely due to fees.

Because costs are one of the few investment elements within individual control, many professional advisers encourage minimising them, making passive strategies an appealing long-term option based on cost-effectiveness alone.

Success Rates and Performance Odds

Another key factor influencing the choice between passive and active investment is the likelihood of achieving above-market returns. While some investors aim to “beat the market,” understanding the odds of doing so through active management is essential to making an informed decision.

Active performance against benchmarks

Despite the appeal of potential market-beating returns, the data consistently shows that the majority of active fund managers underperform their benchmarks over time. The SPIVA (S&P Indices Versus Active) Scorecard, which tracks the long-term performance of actively managed funds, paints a sobering picture. According to the SPIVA U.S. Year-End 2023 report, over a 10-year period, approximately 85% of actively managed large-cap equity funds underperformed the S&P 500.

Similar trends are evident in global markets. In the UK, over 80% of active UK equity funds failed to outperform the FTSE All-Share Index over a 10-year horizon. The consistency of these results across various market cycles strongly suggests passive strategies offer more reliable, albeit non-exceptional, long-run outcomes for most investors.

Reasons for underperformance

Several factors contribute to the consistent underperformance of active managers:

• Higher costs: As discussed previously, active management incurs greater expense, creating a performance hurdle before returns even begin to outpace benchmarks.
• Market efficiency: In developed markets, stock prices generally reflect all available information. This reality makes it difficult for skilled managers to find and capitalise on mispriced securities consistently.
• Behavioural hurdles: Active managers may be influenced by psychological biases or institutional pressures that lead to suboptimal decision-making, such as herding, short-termism, or style drift.

Role of skill and luck

While a small subset of active investors does manage to outperform, pinpointing consistent winners in advance is exceptionally challenging. Some outperform due to skill, but many do so due to chance. Moreover, previously successful managers often struggle to replicate earlier outperformance. As Nobel Laureate Eugene Fama noted, distinguishing luck from skill in investing is one of the greatest challenges facing both researchers and practitioners.

Passive performance expectations

In contrast, passive investing doesn’t seek outperformance but rather aims for broad market exposure at minimal cost. While it forgoes the opportunity to beat the market, it likewise avoids the risk of underperforming due to poor manager selection or excessive fees. Passive investors, therefore, align themselves with the central principle that “you don’t need to beat the market to do well—you only need to invest into it efficiently.”

In the context of long-term asset growth, the odds strongly favour passive investing as the more reliable and statistically superior approach, especially for individual retail investors.

Time Commitment and Complexity

The amount of time and effort required to implement a chosen investing strategy can significantly influence the decision between passive and active investing. While some investors enjoy researching stocks and speculating on market direction, others prefer a hands-off approach requiring minimal oversight.

Effort required for passive investing

Passive investing is synonymous with simplicity and automation. Once a diversified portfolio is set up, often using low-cost index funds or asset allocation ETFs, there is little requirement for ongoing involvement. Rebalancing periodically—typically once or twice a year—is the extent of interaction that passive investors generally require. For investors using robo-advisers or managed platforms, even rebalancing can be automated entirely.

This makes passive strategies highly suitable for busy professionals, beginners, and those seeking to “set it and forget it.” Time required is minimal post-setup, and the ease of implementation often reduces the emotional stress commonly associated with active market watching and adjustments.

Complexity of active investing

In stark contrast, active investing demands substantial time, energy, and skill. Active investors must continually research macroeconomic trends, sector developments, and individual companies. Daily or weekly monitoring of news, earnings reports, and technical charts is generally required to make informed decisions. This workload is intensified further by the pressure to outperform benchmarks.

Moreover, active investing involves complex decision-making regarding:

• Security selection
• Entry and exit points
• Risk management strategies
• Position sizing
• Tax-loss harvesting or selling winners strategically

This complexity often requires professional managers or a substantial personal time investment. Missteps in research or execution can materially impact performance, which partly explains the variance in active manager outcomes.

Emotional discipline and behaviour

The psychological aspect of investing cannot be ignored, especially in active strategies. Remaining disciplined during market volatility is more difficult when one is actively involved in investment choices. Behavioural finance studies show that individual investors often hurt their returns by acting on fear or overconfidence, such as selling during downturns or overtrading during upward markets.

Passive investing mitigates many of these risks by removing much of the judgment and variance involved in decision-making. Staying fully invested in an index through all market cycles allows for consistent compounding and avoids market timing errors.

Summary of time factors

Ultimately, the passive approach aligns with those who want an efficient, low-maintenance, and statistically sound way to grow wealth over time. In contrast, active investing may suit those with a passion for markets, deep knowledge, ample time, and a high risk tolerance who are seeking to strategically outperform market averages. However, one must be realistic about the input required and the constrained odds of long-term success.