Active and passive investing: what is the difference?

Active and passive investing: what is the difference?

Jonathan Webster-Smith, Investment Team Director from Brookes Macdonald

Brooks Macdonald Asset Management is often asked its views on active and passive investment management. Multi-Asset Portfolio (MAP) managers choose each underlying fund within their portfolios using their expertise and experience based on an active or a passive approach to investment management. The underlying funds within the MAPs are managed by third party fund managers, who can, in turn, also take an active or passive approach. In this interview, Jonathan Webster-Smith, Investment Team Director from Brookes Macdonald explains both approaches, together with their respective advantages and disadvantages.

What is an index?
All securities traded on the market provide exposure to different sectors, such as cash, equities, bonds and their subcategories, as well as tangible assets such as property. An index is a group of securities traded in the same sector of the market, serving as a performance indicator for that market. For example, the FTSE 100 Index is one typical index that measures the performance of UK’s 100 largest companies, measured by the total values of all outstanding shares (market capitalisation). It is often set as a benchmark to outperform.

What is active investment management?
An active investment management approach aims to beat the returns from the stock market or specified index, and capital is allocated according to the judgement of the investment manager.

Active managers believe the market can be beaten. Prevailing market trends, the economy, political and other current events as well as company-specific factors (such as earnings growth) will all affect an active manager’s decisions. While they can not beat it all the time, many active managers do believe there are certain irregularities in the market that can be taken into consideration to achieve potentially higher returns.

What is passive investment management?
A passive management approach (commonly known as ‘indexing or ‘tracking’) allocates capital according to the stock or sector weightings* of an index.

Passive managers generally believe that it is difficult to beat the market. They do not make the investment decisions regarding which securities to buy and sell: they simply replicate the index by purchasing the same securities included in a particular index. A passive manager aims to match the returns from the stock market or specified index/sector, rather than to outperform them.

*usually based on the proportion of a stock’s market capitalisation in the index

Which approach works best?

Whether investors choose active or passive management it is important to remember that past performance is not a guide to the future. The value of an investment can go down as well as up and neither is guaranteed.

Active investment management can add value but not every active manager can outperform the market every time. Therefore there is a risk associated with this strategy. The choice of manager can become one of the most important decisions an investor can make when going down the active route.

Investors who prefer a passive strategy often take comfort in the knowledge that the performance of their investment will largely match the index that they are replicating. Both strategies work and can even be complimentary when combined to form an overall investment strategy.

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