Private investing is an alternative investment involving active investing in private companies, private equity funds, or other assets not traded on public markets. Private investing can offer higher returns, lower correlation, and greater diversification than public market investments, but it also entails higher risks, costs, and illiquidity. Therefore, private investors must choose the right investment strategy, such as active vs passive investment, that suits their goals, preferences, and risk tolerance. Private investors need to consider the trade-offs between active vs passive investing when making decisions in this space, as these choices can significantly impact their investment outcomes.
One of the main choices that private investors face is whether to adopt an active or a passive investment strategy. Active management, often facilitated through mutual funds, involves selecting and managing individual investments or funds based on research, analysis, and market timing. This approach requires active investors to make ongoing decisions about when to buy or sell specific assets within the fund's portfolio. In contrast, passive investing involves tracking and replicating a market index or benchmark with minimal intervention and trading. Both strategies have pros and cons; this article will compare and contrast them for private investors.
Active vs passive investing can offer higher returns than passive investment by exploiting market inefficiencies and opportunities. Active investors can use their skills, knowledge, and experience to identify undervalued or mispriced assets, anticipate market movements, and adjust their portfolios accordingly. Active vs passive investing can also tailor their portfolio to their specific risk preferences, investment objectives, and personal values.
However, active investing also involves higher costs, risks, and taxes than passive investing. Active investors must pay higher fees for active management, research, trading, and administration. Active investors also face higher risks of underperforming the market or losing money due to human errors, biases, or bad luck. Active investors also incur higher taxes due to more frequent capital gains realization and short-term tax rates.
Active vs passive investment is a comparison that underscores the challenges of active investing. Active investors must find and evaluate skilled fund managers who can beat the market over the long term, which is rare and hard to predict. According to an S&P Dow Jones Indices study, only 11% of US large-cap equity funds outperformed the S&P 500 over the 10 years ending in June 2020.
Another study by Morningstar found that only 24% of US active funds survived and outperformed their average passive peer over the 10 years ending in December 2019. These statistics highlight the stark contrast between active vs passive investment approaches, with passive investment strategies often offering more consistent and cost-effective alternatives for many investors.
Passive vs. active investment can offer lower costs, risks, and taxes than active vs. passive investment. Passive investors can access various low-cost passive funds that track various market segments and asset classes, such as index funds, exchange-traded funds (ETFs), or mutual funds. Passive investors also reduce their risk of underperforming the market or losing money by diversifying their portfolio across many holdings and following a buy-and-hold strategy.
Passive investors also enjoy lower taxes due to less frequent capital gains realization and long-term tax rates. The passive approach is often more cost-effective and tax-efficient when comparing active vs passive investment. Passive investing can also provide consistent performance that matches or closely follows the market benchmarks. Passive investors do not have to worry about finding and evaluating fund managers or private market funds that can beat the market, which is uncertain and unreliable.
Passive investors can choose a fund that tracks a well-known and widely accepted index or benchmark, such as the S&P 500, the MSCI World, or the FTSE 100. Active vs passive investment, however, has some limitations and drawbacks. Active vs passive investment, passive investing limits the potential for outperformance and does not allow for customization or control over investment decisions. Active vs passive investment: passive investors have to accept the returns and risks of the market index or benchmark they follow, which may not suit their goals or preferences.
Active vs passive investment: passive investors also have no say in how the index or benchmark is constructed or maintained, which may involve rebalancing frequency, weighting methodology, inclusion criteria, or environmental, social, and governance (ESG) factors. In contrast, active management allows investors to make decisions and influence these aspects, potentially tailoring their investment strategy to align more closely with their specific objectives and values.
The performance of active vs. passive investing depends on various factors, such as the time period, the market cycle, the investment goal, and the asset class. Active investing generally performs better in inefficient markets with more opportunities for mispricing and arbitrage. Active investing also tends to perform better in volatile markets with more chances for market timing and tactical allocation.
Active investing also performs better for specific investment goals that require customization or specialization. For example, growth equity funds are an active investment that seeks to invest in fast-growing private companies with proven business models and strong cash flows. Growth equity funds can offer higher returns and lower risks than venture capital funds, which invest in early-stage startups with uncertain prospects.
On the other hand, passive investing tends to perform better in efficient markets with fewer opportunities for mispricing and arbitrage. Passive investing also performs better in stable markets with fewer chances for market timing and tactical allocation. Passive investing also serves better for broad investment goals that require diversification or exposure.
For example, according to S&P Dow Jones Indices, active US large-cap equity funds underperformed the S&P 500 by 5.2% on average over the 10 years ending in June 2020. However, active US small-cap equity funds outperformed the S&P SmallCap 600 by 1% on average over the same period. Similarly, according to Morningstar, active US large-blend funds underperformed their average passive peer by 0.74% on average over the 10 years ending in December 2019. However, active US small-value funds outperformed their average passive peer by 0.86% over the same period.
There is no definitive answer to whether active or passive investing is better for private investors. Both strategies have advantages and disadvantages, and the optimal choice depends on the individual investor’s situation and preferences. However, some general recommendations or tips for private investors who want to choose between active and passive investing strategies are:
Active vs. passive investing is one of the critical decisions private investors must make when investing in private markets. Both strategies have pros and cons, and the best choice depends on the individual investor’s situation and preferences. When choosing between active and passive investing strategies, private investors should consider their risk tolerance, time horizon, investment objectives, and personal values. Private investors should also evaluate the performance, fees, reputation, and style of different fund managers or private investment funds when selecting between active and passive funds. One of the ways to do this is to review their financial statements and compare their returns, expenses, assets, liabilities, and cash flows. Private investors should also diversify their portfolios across different asset classes, sectors, regions, and strategies when allocating between active and passive investments. Private investors should also monitor their portfolios regularly and rebalance when necessary to achieve their investment goals.