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Lesson 1-Passive and Active Investing

Updated: Oct 15, 2021

Passive Investing Explained:

Passive investing refers to a buy-and-hold strategy for long-term investment horizons (over 10 years). Passive investors ignore short-term market fluctuations under the assumption that the market will post positive returns over the long run.


This assumption is based on the continuation of the following historical trends; US GDP has grown from $1.088trn in 1970 to $21.43trn today and the average annual return of the S&P 500 Index since 1926 is approximately 10-11%. In the words of the famous investor Warren Buffet, ‘since 1942, we’ve had 14 presidents, world wars, 9/11, and the Cuban missile crisis. The single best thing you could have done on 11/03/1942 was buy an index fund and never look at a headline. If you had put $10,000 in an S&P 500 index fund that reinvested dividends you would have approximately $51,000,000 today and the only thing you had to believe in is that America would progress as it has since 1776’, (Warren Buffett Interview ).


The most common type of passive investing is buying an index fund or ETF which tries to replicate the performance of a given index by holding the same stocks, bonds, or other assets from the index in the same proportion. For example, the S&P 500 Index includes the 500 biggest companies in the US weighted by market cap, meaning bigger companies make up a greater proportion of the index. It is not possible to invest directly in an index, so companies such as Blackrock, Vanguard, and State Street have made S&P 500 index funds and ETFs which track the performance of the S&P 500 Index by including the same stocks from this index in the same proportions. (Vanguard S&P 500 ETF, Blackrock S&P 500 ETF, and State Street S&P 500 ETF).


A Vanguard S&P 500 Index Fund, ticker symbol VFIAX, (Vanguard S&P 500 Index Fund ) and a Vanguard S&P 500 ETF, ticker symbol VOO, (Vanguard S&P 500 ETF) should both hold the same assets in matching proportion. The main difference between an index fund and ETF is that to buy a Vanguard index fund an investor must be able to set up a Vanguard account and must therefore be a resident of one of the following countries contained in the link (link to list of countries ). If an investor is not a resident of at least one of the aforementioned countries, they can open an account with an online broker such as Interactive Brokers and buy VOO, which is the ETF equivalent of VFIAX. While Vanguard index funds can only be purchased on a Vanguard account, Vanguard ETFs can be purchased by anyone with access to the US stock market.


Active Investing Explained:

Contrary to passive investing, active investing involves extensive independent fundamental/technical analysis and microeconomic/macroeconomic analysis of factors that influence the value of an individual investment. Active managers conduct this analysis to know when to pivot into or out of a particular asset. The goal of active investing is to try to beat the stock market’s average returns (achieve higher returns than the S&P 500). They also try to ‘time the market’ which involves anticipating movements in the price of an asset and frequently trading in an attempt to profit from these short-term fluctuations.


An individual can invest in mutual funds and actively managed index funds/ETFs. These funds are run by portfolio managers who select investments based on independent assessments of each investment's worth, constantly evaluating and trading stocks/bonds and other financial assets. Typically, each actively managed fund will include stocks/bonds from a particular industry or country (actively managed fund investing in disruptive technologies and actively managed fund investing in medium and smaller sized Japanese companies).

Actively managed funds allow investors to benefit from the financial expertise of the professionals managing the fund due to the greater involvement they have in deciding which financial assets to include in the fund portfolio and when to sell them. Successful active investing requires the manager's viewpoint on the price movement of stocks to be right more often than wrong. Active managers need to know exactly when to buy and sell a stock and can misjudge the market by choosing underperforming stocks. Therefore, if an investor wishes to buy an actively managed fund they need a high appetite for risk.


Advantages of Passive Funds:

Low Cost and Higher Returns:

Passive funds do not try to beat the returns of the index they track. Therefore, they do not employ research analysts/portfolio managers who would try to beat the returns of the index by stock picking, making them low-cost investment vehicles. The average expense ratio (annual fee) of passive funds in 2019 was 0.13% compared to 0.66% for active funds, over the long run higher fees greatly diminish returns. In addition, passive funds incur lower transaction costs (i.e. lower taxes on capital gains) due to lower transaction volumes in the fund. As a result, after accounting for expenses, passive funds often produce superior post-tax results compared to active funds over the medium/long run.


In 2019, 71% of US active funds lagged the returns of the S&P 500, partly due to the difficulty in outperforming the benchmark index while covering the fund's expenses. Over the long run, consistently beating the market whilst covering expenses becomes increasingly difficult for active funds. While a fund manager may be able to outperform the S&P 500 over the short-run (2-3 years), this does not persist. Over a 10-year period, 85% of large-cap active funds underperform the S&P 500 and after 15 years nearly 92% trail the index. As a result of this, passive investing has become popular among non-professional investors due to its low-cost and research-free investing which beats a significant majority of its active counterparts over the long run.


Risk:

Active funds try to beat the returns of the benchmark index. As a result, active managers try to find market inefficiencies (profiting opportunities) in the market before other active investors. Finding market inefficiencies includes buying long positions in undervalued stocks or short positions in overvalued stocks. Given that the market is highly competitive, even if an active manager makes large short-term profits, it becomes increasingly difficult to consistently find market inefficiencies before other active investors. Therefore, after accounting for fees, most active funds incur higher losses and take on more risk than the benchmark index over the long run. Passive investing is therefore more suitable as investing is not about making money fast but rather building wealth by compounding gains over the long run with reasonable risk exposure.


Additionally, incorrect forecasts due to misleading research and analysis for the price movements of stocks is an issue that applies to active and not passive funds, making passive funds lower risk. Given that the main stock markets are considered highly efficient, misjudging the price movement of a stock can arise due to information influencing a stock’s price being priced into the stock too quickly for the majority of active investors to profit from. For example, if India announces that they are subsidizing the sales of electric cars, active investors may buy into stocks like Tesla, as a result, the stock price would increase. Once the stock price stops increasing, investors consider this positive information to be priced into the stock. If an active investor then buys Tesla stock after this point, they will not profit from this information. In the stock market, based on the efficient market hypothesis, information is priced into stocks extremely quickly due to the high level of efficiency by which it operates, making it very difficult to profit from news affecting any given stock. Additionally, active investors can make human errors. These include miscalculating the true value of a stock (correct price of a stock), which can lead to inaccurate forecasts on how much the stock price will increase/decrease following the release of positive/negative information.


Furthermore, as stated by the famous economist John Keynes, ‘markets can remain irrational longer than you can remain solvent. Meaning even a rational active investor can incur losses due to the unpredictable nature of the herd. For example, active investors betting against the housing market before the 2008 crash would have incurred losses as the majority of investors were holding long positions on this market despite the high number of subprime borrowers. The rise in subprime borrowers eventually resulted in high default rates on mortgages and the collapse of the housing market. Therefore, active investors cannot always navigate the sometimes irrational behavior of the market.


Lastly, passive funds are more transparent as it is always clear which assets are in the index. For example, in VOO which tracks the S&P 500 Index, up-to-date holdings are published regularly (link to VOO holdings ).


Diversified:

Index funds/ETF’s are prime examples of naturally diversified investment vehicles as they include many stocks which are typically from many different sectors. For example, the S&P 500 Index currently holds 505 stocks from 11 different sectors including Technology (27.60%), Health-Care (13.44%), Financials (10.34%), Industrials (8.47%), and Real Estate (2.41%). Diversification reduces risk levels by reducing investors' exposure to the performance of a certain sector or country.

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