Being active is one of the most advocated messages from doctors - it not only helps in losing weight but rather is an essential part of being fit & generally healthy. While physicians might be prescribing being active to improve one’s physical health, an increasing number of “financial doctors” around the world are asking their clients to become passive in an effort to boost their financial wellbeing. In the recent years, this trend is starting to emerge in India as well.
The active vs. passive debate is one of the most widely discussed topics in the world of investments. And since it’s also a relevant one for most investors, it’s very important to first exactly understand what these terms mean. While there are numerous definitions floating around, we define these two investing styles as follows:
Active: is when an individual or fund handpicks stocks or securities, taking active calls depending on market conditions and their subjective market views
Passive: is when an individual or fund follow a systematic rules-based approach to selecting stocks that is predefined and doesn’t involve any “active” or subjective calls
At its simplest, investing passively could mean buying a popular index like the Nifty-50 via a passive index fund or an ETF - since indices also follow a predefined systematic methodology, this would be a passive investment that aims to replicate the return of the Nifty-50. What this means is that any amount you invest, the fund will allocate that money across the 50 stocks in a manner that’s pre-defined by the NSE (in this case, it’s based on the market-cap of the stocks). Its active equivalent would be a large-cap fund where the manager aims to outperform the Nifty-50 by investing in a manner different from the Nifty-50.
While passive investing has been around in theory since 1960s and in practice since Jack Bogle launched the first index fund in 1976, it only gained widespread popularity in the last 10 years since Lehman Brothers collapsed in September 2008 and the entire global economy entered got engulfed in a financial crisis.
That’s because after the financial crisis, institutional and retail investors started to embrace the philosophy that consistently beating the market is very difficult for managers, and even more difficult is identifying in advance which of these managers will outperform. The costs associated with active investing became very difficult to justify for most investors, and as such the focus shifted to keeping costs low by investing in passive strategies.
Note that one of the biggest reasons why passive investing has grown across the world is to do with low-cost, which in turn mainly comes from investing systematically based on pre-defined rules. Such a strategy enables the fund to not employ research teams and/or portfolio managers, thus saving on costs. As such, the real debate isn’t between active vs. passive - it’s between low-cost vs. high-cost and systematic (rules-based) vs. subjective (forecast-based).
Active and passive just happen to be on opposite sides of both these arguments. If tomorrow active investing is available at a lower cost than passive, I’m certain this debate will again evolve & many advocates of passive will have to rethink their position.
But until then, consider becoming actively passive by investing your money in low-cost and systematic strategies that are better for your long-term financial well-being.