Active versus Passive investing

There are two types of investing in the Stock market – Active and Passive. 

Active investing

The individual or a fund goes through the individual companies trading publicly in an exchange and picks the ones that have the most chance of giving a good return on the investment. 

Passive investing

There are indices like the Dow, S&P 500 and NASDAQ. There are funds that are built around these indices, that just purchase the index as a whole. The funds allocated to each company in the index is weighted by the market cap (total number of shares multiplied by the stock price). 

Let us dive deep into these strategies.  

Active investing vehicles

DIY Stock picking

If you are an individual investor and buying shares of companies, you are doing active investing. Hopefully you are going through those companies that are in your circle of competence. You know how to read income statements, balance sheets, and cash flow statements. You know how to evaluate the competitive edge of a company; you understand the industry and the size of the market the company is serving. Looks pretty daunting right?  

You also need to have the right mindset to face the huge volatility that happens in common stocks. Factor in the fear of the total loss of capital due to not understanding all the parameters, this is a highly risky approach. 

Mutual Funds

The other thing you could do is to pick a Mutual fund. A Mutual fund is a financial instrument where money is collected from many investors and this is invested in stocks, bonds and other assets. This is run by a professional money manager and his team of analysts. To invest the money on your behalf, the fund charges a fee on your money. If you make 8% from your return and the fund charges you 3%, then you return is actually 5%. For you, the advantage is the diversification that is available. You get a slice of every company that the fund has purchased the securities for.  

The price of a mutual fund is referred to as Net Asset Value (NAV) per share. This is obtained by calculating the total value of the securities held in the fund divided by the total number of shares outstanding. This NAV per share is computing at the end of each trading day. When you purchase a share, this is the price that you pay.  The most famous fund management companies are Fidelity, The Vanguard group, T. Row Price etc. 

There are different funds available from these companies based on the need of the clients. There are growth funds which invest in growth companies, income funds which invest in either dividend paying stocks or bonds, International funds that invest in other countries. All these flavors are available and based on your financial goals and risk appetite, you will always have something to choose from.  

But how do you pick a fund when you have so many options available. Morningstar is a good resource that lists the mutual funds, the performance of the fund, fees etc. One thing that is clear until now is that this not just active investing by the fund manager in picking stocks, but on your part as well because you now have to DIY pick the fund.  

Every year S&P produces a report SPIVA (S&P Indices versus Active) that lists the percentage of the active funds that beat the index over a 1, 3- and 5-year period. It’s very interesting to see that more than 70% of the funds fail to beat the market. Why pay the high fees and taxes when you can’t even beat the market? 

Hedge Funds

Hedge funds are special investment vehicles that are again managed by an active Fund manager, whose goal is to get returns irrespective of whether the market goes up or down. This is achieved by hedging the positions. There are different strategies long/short equity positions, arbitrage, trading currencies, commodities, real estate etc. Anything under the sun! The investments made are high risk. A lot of leverage is employed. 

The news is not everyone can invest in hedge funds. It is open only to accredited or qualified investors, this means that one needs to have a net worth exceeding $1 million or an annual income of $200,000 or more for the previous two years. These are kind of a private investment vehicle and there is not much oversight from the SEC. There may be a requirement for the money to be locked in for a period of years. 

The fee structure is usually called two and twenty (2 and 20) wherein a 2% asset management fee is charged and another 20% is taken from the gains achieved. These funds may be run by activists as well. The activist investors are those that taken sizable positions in a public company, overthrow the board, appoint new managers and try to unlock the value in the company. After the company gets profitable, they sell and exit their position. 

Now the big news is that most of the hedge funds fail to beat the market! Leave aside the bull markets, but even when the market is down, they fail to achieve their goal of hedging and trail more than the market. There have been instances where the whole fund blew up because of the amount of the leverage used and over confidence of the fund managers (read up more by searching for Long-Term Capital Management LTCM). 

Passive Investing vehicles

Index Funds

Jack Bogle comes to the rescue for the common investor. He was the founder of “The Vanguard group” and is credited with creating the first index fund. During his college, he studied the mutual fund industry and he put together his thesis “The Economic Role of the Investment Company”. His idea was instead of trying to beat the market, why not create a fund that would mimic the market. Thus, the performance of the fund is directly tied to the performance of the market. And if the fund is held over a long period of time, one can get the upside of the market without undertaking unnecessary risks. He created the first index mutual fund after founding the Vanguard Group. He is the author of the bestseller book “Bogle on Mutual Funds: New Perspectives for the Intelligent Investor” 

When the index fund launches, it failed to raise capital, falling 95% short of the goal! This was a revolutionary concept and people were not ready. But with time, the popularity of index funds has skyrocketed. Warren Buffet, the most successful stock picker, says that most investors and pension funds are better off investing in index funds. This is a real tribute to the effectiveness of index investing. About 45% of this market is controlled by index funds which is almost half of the entire stock market. 

These funds are characterized by extremely low fees (0.04%) because there is no middle man (the fund management team). The total market cap of the US Stock market is about $37 Trillion. There is not much selling of the securities by the fund as well, as they just mirror the index and the indexes do not change frequently. If you own index funds in your IRA accounts, the money can grow with minimum costs. And for your regular accounts, if you do not sell these funds, there is no capital gains tax as well. How tax friendly this strategy is! 

The famous story of a tortoise and hare comes to mind. The slow tortoise was able to beat the fast hare by being consistent. The same goes for index funds versus short term trading of stocks. The capital gains and losses eat up in the profits and over a long-time horizon, trading sucks compared to index investing. 

There is a concern about the lack of corporate governance arising out of indexing. Since whole index is purchased and huge share of the largest companies’ stock is owned by index investors, there is not much motivation to enforce governance. This may result in lowering of the ethical standards by the big corporations. However, with the advent of the ESG investing (environmental, social, and governance), there is a push towards socially responsible investing. This may be the antidote for the concern of the lack of governance. 

Some of the major index funds are Vanguard Total Stock Market Index (VTSMX) and Fidelity Total Stock Market Index (FSTMX). 

Exchange Traded Funds (ETF)

ETFs are also index funds but the key difference is that while an index fund is a Mutual fund, an ETF is traded like a stock, so there is a scope for intraday trading. This may lead to the risk of capital losses and trying to time the market, which opens the door for speculation versus investing. The best strategy is to buy and hold and forget. There are different ETFs available and some of the risky financial instruments are also packaged as an ETF. So, it is very important to invest only in total market index ETFs. 

The following is a table comparing Stock trading, Mutual funds and Index investing (ETFs included):