Active VS Passive Investing: What's Best For Me?
If you were enrolled in a F1 Fantasy league with your friends, would you be better off hand-picking your favourite F1 teams and drivers on the expectation they will win the world championship, or would you be better off buying the entire line-up of F1 teams and drivers (let’s say by betting a little bit in every team and driver)? The answer isn’t that straightforward - and the same applies to investing.Let's touch on the differences between active and passive investing. It’s a topic that is often discussed at investment boardrooms and a hot debate among fund managers.
First, passive investing usually involves buying a fund that closely tracks an index, which is a basket of securities, like the IHSG (Indeks Harga Saham Gabungan) or the S&P 500, to achieve long-term market returns. Active investing, meanwhile, is a style of investing where a portfolio manager tries to beat the market’s average returns or selected index by choosing certain securities over another, and taking advantage of short-term market fluctuations.
There are advantages and disadvantages between both types of strategies - and may sometimes be used simultaneously, but this depends on investment objectives. The key benefit for passive investing is that it typically involves lower trading fees because the fund typically tracks an index, where for example the fund will buy all of the stocks in the IHSG Index in the same proportion they represent in the index. Usually, passive fund strategies are perceived to have lower risk because they track market returns quite closely. However, the downside is that the returns might be lower if the market is generating low returns as a passive fund simply tracks the value of the overall stock market.
On the other hand, active investing involves portfolio managers taking an active role in managing the fund to pick stocks or bonds to buy the portfolio manager thinks will outperform the benchmark or market, and often has higher trading fees and higher risk against the market. However, actively-managed funds can generate higher returns compared to the benchmark or market, if the portfolio manager is able successfully select the right securities that outperform.
In order to understand what investing style makes sense here, let’s take a look at the Indonesian stock market.
- If you had invested money in February 1993 into the IHSG Index, and held on to the investment until the end of June 2022, you would have generated an average annualised return of 11.2%. That’s basically close to a 22x return within 29 years of holding the investment!
- However, if you invested in early July 2012 and held it till the end of June 2022, you would have achieved an average annualised return of 5.4% for 10 years - not too bad.
- Now, if you had invested in July 2017 and held it till the end of June 2022, you would have achieved an average annualised return of only 3.1% for 5 years!
Similarly, let’s take a look at the S&P 500, which is in US dollar terms.
- If you had invested in February 1993 till today, you would have achieved a 7.7%.
- In early July 2012, an average annual return of 11.2%
- In early July 2017, an average annual return of 9.6%.
The key takeaway to this is that the Indonesian stock market, while having achieved reasonable long-term returns for a stock investor, has shown diminished returns more recently. Meanwhile, the S&P 500 has shown more consistent returns similar to its long-term market runs throughout the time periods.
While passive investing is a great way to invest and stay diversified not only in the US and Indonesian market, it offers access to build globally-diversified portfolios (we’ll speak about this next time). However, when just speaking about the Indonesian market, we think that passive funds may not be good enough now to generate consistent, long-term market returns to meaningfully grow your wealth in Indonesia, unlike in the US.
Therefore, we think it makes sense to have actively-managed funds to generate consistent, long-term market returns for our investors. This means we choose to actively select stocks and bonds that we invest into our portfolios, depending on each strategy, to try to beat the market average returns.
While this is our hope, it doesn’t come without risks. You might see higher trading fees to benefit from the short-term price fluctuations, or favouring certain stocks or bonds vs. the market index that we think can give the best overall risk-adjusted returns. Throughout the process, there might be times where we deviate from the market or even underperform against the market in certain periods. But the overarching goal is clear: it’s to beat the market average returns consistently, over the long run.
As retail investors investing in a fund, whether active or passive, we think that investing is an active decision. It involves what you decide to do with your hard-earned savings to meet your investment goals. Because of that, we believe guiding you every step of the way on how we manage your money transparently is important and core to our principles.
Stay tuned as we continue to build our investment products for you!
The author is Co-Founder of Simpan. Julian has over 6 years of experience in Private Equity and Investments, and currently sits on the Investment Committee of Asiantrust Asset Management. Julian earned a Master’s Degree from the London School of Economics & Political Science, and a Bachelor’s Degree from the University of Exeter.