Investing Basics: ETFs – Passive vs Active Investing
ETFs are most often associated with passive index-tracking strategies, but they have a role to play for investors trying to beat the market, too.
Active investors either pick individual stocks or put their money into funds run by managers who aim to do better than average, or to judge the best times to get in and out of different assets.
Fifty years ago, passive investing as we think of it today didn’t exist, tracker funds had not yet been invented and stock market indices were only used as benchmarks.
All investing was essentially active until index funds were devised in the 1970s as academic research revealed that the majority of active fund managers failed to beat the market.
Their creators used mechanical rules instead of expensive managers to construct index-following portfolios at a fraction of the cost of active funds; Exchange Traded Funds (ETF) are their modern incarnation, covering all mainstream markets and asset classes, making the construction of a diversified, low-cost DIY passive portfolio a realistic prospect for anyone.
Passive investing tends to beat active investing
You might think passive investing sounds rather defeatist, but evidence shows most active managers do not beat the market – or at least not by enough to cover their fees – thus investors would achieve higher returns if they’d simply tracked the index.
When financial firm Vanguard surveyed all the active funds available to UK investors, it found that over 10 years 70% lagged their benchmarks; even successful fund managers’ winning streaks don’t tend to last, which means investing in funds that have been doing well recently is not a recipe for success.
A passive strategy based on asset allocation and regular savings avoids wealth-sapping bad behaviour whereby investors buy funds when they’re popular and the stocks they own are expensive or in fashion, and sell them when they’re cheap and unpopular.
A range of ETF trading strategies exist for those looking to beat the market:
- Sector rotation – trading in and out of different sector ETFs to try to exploit the economic cycle.
- Theme-based investing – looking for ETFs that track companies that you believe will outperform because, for example, they are based around a particular technical innovation.
- Tactical allocation – increasing exposure to cheaper or more promising countries or assets, and eschewing more expensive ones.
- Short-term trading – those who want to test their mettle, trading ETFs can be cheaper than shares, attracts no stamp duty and there can be better liquidity.
The passive versus active debate comes down to personal choice.
There is evidence that most people are best served with a passive, long term, investment strategy, keeping a tight rein on costs; however, there will always be those that are allured by the prospect of beating the market.
Perhaps the answer is that you do both – make sure that the largest proportion of your wealth is passively invested for the long-term and keep yourself a small speculative portfolio for your market call investing ideas.