Understanding the Reasons of the Shift from Active to Passive Investing

A recent report released by the Investment Company Institute (ICI) stated that passive fund investments have crossed active fund investments and reached an $11 trillion benchmark in 2020. A significant shift in investment styles can be seen across the world. Investors are slowly moving major portions of their investments from active to passive funds and abandoning fund managers. Both passive funds and ETFs (exchange-traded mutual funds) have been a preferred tool of investment ever since the year 1995. 

Here are some key insights into the two investing styles:

What is active investing?

Active investing predominantly involves fund selection, market timing, stock picking, and continuously reviewing your portfolio. Active funds are primarily managed by dedicated fund managers and their teams who keep altering portfolios as per market situations and investor preferences. All investment decisions, in this case, are made by the fund manager on behalf of investors. The expense ratio is charged in return for the services offered by the manager which usually ranges between 0.25% and 2% (sometimes more) of your total portfolio value. 

A major reason why people started flocking towards passive funds was that they had to pay an additional fee to the fund manager for returns that were almost similar to passive funds. In addition to this, the expense ratio seemed to be a small number initially. However, it totalled up to a considerable amount when it was calculated relative to the investment portfolio. 

But active funds also offer some benefits. They are known to generate inflation-beating returns and provide the utmost flexibility to investors to shift their trades. 

What is passive investing?

Passive investing is a more laid-back approach to investments where investors generally buy index funds or passive mutual funds that replicate the underlying indices. Passive investing is more about tracing and tracking. Although currently there are limited options available in passive funds, investors can choose from them and wait for the fund to touch its benchmark’s return.

Since there is no active fund management, there are no associated fees as well. Passive funds are often used by investors looking for cheaper and more transparent avenues to stock their money. 

What is the difference between active investing and passive investing?

While active funds are always in a rush to outperform the underlying benchmarks and indices, passive funds only aim to imitate the returns generated by those indices. For the same reason, passive funds are cheaper and require less maintenance. 

Why is there a paradigm shift in the investing style: active to passive?

The recent trends and changes in the investment ideology of people can be called a paradigm shift. Investors are adopting a smart investing style that accounts for cross-checking the fund manager’s performance, past tracks, and the overall return their portfolio can generate. 

Earlier, due to a lack of resources and information, it was hard to gauge the investment routine and strategy of the fund manager. However, with plenty of facts and figures readily available now, investors have become aware of the underlying potential of their portfolio as well as their manager. Yet, several active investment enthusiasts discard any logical reasoning behind passive investing. 

Benjamin Graham, known to be the father of value investing, advocated passive investing as a defensive style. According to him, investors who were not willing to put in a lot of effort and work on the active and value investing style were the ones who made the shift to passive investing. However, trends have now changed with both enterprising and defensive investors opting to move towards a passive style. 

Here are some major reasons why more investors are now interested in passive investing over active investing:

1. Higher fees

Since passive funds do not require active management of investments, there is no need to hire a fund manager. This reduces the costs involved in investing. The expense ratio is also negligible in case of passive funds, making them a cheaper option as compared to active funds. 

2. Liquidity and redemption crisis

In the case of active funds, investors tend to redeem their investments when the markets fall to liquidate their assets. This sudden and mass liquidation of active assets leads to a crisis for the underlying fund houses. This eventually leads to fire sales and the overall degradation of the return percentage. 

3. Increasing need for managing assets

With active investing, there is always a need to manage assets, given the extreme market volatility. Since markets can be unpredictable, the investments are bound to fall apart. This requires a good understanding of market timing and the active management of assets. Relying only on the fund manager’s inputs can at times result in lower returns. It may also not live up to your financial expectations and goals. 

4. Higher risk to market volatility

Although no investing style is secure from the increasing market volatility, active funds are more susceptible to risk because of direct exposure. In passive investing, mutual funds and ETFs imitate the movement of the underlying benchmark. The return expectations are set accordingly. In addition to this, since the assets are traded in the form of indexes and not directly liquidated, the overall impact of volatility is reduced. 

5. Trading fee

Apart from the expense ratio that goes into managing the fund, investors bear several other expenses related to active investing. A major portion of these costs can be summed up into the trading fee.

A trading fee is essentially any amount of money or commission that investors pay to sell or purchase assets, trade them for other assets, or for conducting any other business related to active funds. There are no such commissions in passive investing. 

6. Lower tax efficiency

Although in the case of passive investing only ETFs are eligible for tax benefits, there is no such provision in active investments. Investors who predominantly invest in mutual funds with a purpose to save taxes tend to choose passive investment tools like ETFs.

To sum it up

Investing in financial markets requires investors to follow a checklist. However, in the case of active funds, money, time, and effort are required in higher concentrations with a greater potential of risk. On the other hand, passive funds offer a more cost-effective approach to investing and are ideal for laid-back investors. 

It is common for investors to get confused over this recent paradigm shift. You can reach out to financial advisors for better understanding on the most suitable form of investing for your portfolio.