How to (potentially) outperform the market: Active Investing explained

A sore morning…

Hi all! Welcome back to another newsletter.

You may have noticed it landed in your inbox a tad later than usual. I had hoped to write it on Sunday afternoon, but after running my first-ever half marathon, there wasn’t much energy left in the tank yesterday 😉

I’ve never been much of a runner, but this experience has inspired me to write about (financial) goal setting soon!

Passive and Active

Let's turn our attention to this week's topic, though!

Last week, we spoke about passive and active investing.

If you remember, passive investing was purchasing a broad basket of many stocks that represent the market. Not having an opinion on which stocks will do better and just buying “them all”.

This week, the topic is active investing.

If you recall, we defined it as: “you research individual companies and buy and sell stocks in an attempt to beat the stock market”.

Disclaimer

As always, the information I provide is sourced from both reputable sources and my own experiences. I intend to inform you about the financial world and help you make better decisions, but none of the information in this email should be taken as financial advice or advice to purchase certain financial products. Investing involves risk of loss. See our full disclaimer here.

Active investing

Active investing takes a more hands-on approach to investing. You’ll need someone to act like the portfolio manager. This can be you or a professional portfolio manager at an asset management firm.

The goal is to pick the right investments and outperform the stock market’s average returns. And maybe take advantage of short-term fluctuations.

For this, you need deep analyses and know when to ‘pivot’ into or out of an investment.

There’s the data-driven, quantitative approach and the qualitative approach, which relies more on the expertise and opinion of analysts. Often, a combination of both is used.

Benefits of Active Investing

Before the rise of passive investing, active investing was the default operating method. And these benefits show you why:

Flexibility

You’re not obliged to follow a specific index. So you can buy whatever you think is best and find those “diamonds in the rough”.

Room for opinions

In line with our first benefit, this means active managers can actually have an opinion about what they invest in. For example, suppose there are companies they don’t like or specific concerns regarding sustainability or other principles. In that case, it’s easy to simply not include them in their investments.

Chance of outperformance

With a passive fund, you know what you’ll get: the market performance (whatever that is) minus the fees of the fund you’re in.

With active investing, there’s a chance that you outperform the market as you manage to pick better investments.

Hedging

Active managers can also hedge their bets using techniques like “short sales” and “put options”. We’ll talk about them later, but it’s basically betting on prices to drop while maybe also betting on them to go up, so you don’t lose as much if you’re wrong.

Furthermore, they can, of course, simply sell an investment if they feel it is overpriced or the risks have become too big. Passive managers can’t do this, as they have to follow the index!

Disadvantages of Active Investing

Expensive

According to The Investment Company Institute, the average cost for an actively managed equity fund is 0.68% of the money you put in. So compared to the 0.06% of the average passive equity fund, you’re losing a lot of money in fees.

These fees are much higher because you’re paying for the salaries of the analyst team researching all those stocks. And there are transaction costs caused by the buying and selling, which tends to happen much less in a passive investing fund.

Active risk

This is the other side of the medallion. Yes, active investing brings a chance to outperform. Still, it also has a (perhaps greater, keeping fees in mind) chance to underperform too!

If the active manager and the analysts are wrong, you could do much worse than the market on top of the extra fees you paid.

There are no guarantees in the world of investing!

So, what to choose?

You might think that a professional money manager’s capabilities would trump a basic index fund. But statistically, they don’t.

Many studies have shown that passive performs better on average:

Research from S&P Global found that, over a period of 15 years (ended in 2021), only about 4,5% of professionally managed portfolios outperformed their benchmarks.

After taxes and trading costs, they name the number of successful funds being less than 2%. 😅

There are significant differences per asset category, though, so you certainly shouldn’t assume active investing never works.

You can check out the full study here.

But it’s not only returns that matter, but “risk-adjusted returns”. Meaning: how much do you get for the risk that you’re willing to take.

Controlling the amount of money that goes into certain sectors or companies can be really beneficial when the situation in the market is changing quickly.

Overall

All the evidence of passive beating active might be an oversimplification of something quite complex.

In the end, active and passive investing are different sides of the same coin, and many professional investors use both in their portfolios.

As I mentioned last week, I personally go for about 80% passive and 20% active.

This brings us to our final topic: what do you want?

If you are very interested in investing and want to put time into it, then active investing might be for you.

Or you might be in it for the memes (Gamestop, anyone?).

If you’re doing it to “scratch an itch”, you can definitely do the active investing yourself.

However, suppose you don’t want to put the time and effort into it. In that case, I’d suggest you either stick to passive or pick a nice actively managed fund so a professional can do it for you.

You can go to any asset manager out there, big or small, and your broker’s platform will have plenty of options.

Choosing comes down to your confidence in the specific asset manager, their team, their way of working and maybe their past results. Though past results are never a guarantee for the future 😉