Active or passive investing? How to pick the right strategy for yourself


Is this a good time to buy equity? The answer must be a yes or no. Investing expertise is judged by the ability to provide guidance about the future; or better still, offer advice about buying or selling that results in a clear profit or protects from a steep loss.

Timing and selectivity are primary contributors to investment success. Timing is about moving in or out of an asset class, based on an understanding of the macro environment and market cycles. When an adviser asks you to “book profits”, they want you to move money from equity to cash, so that you are protected if there is a correction in equity. Timing is thus an asset allocation decision.

Selectivity is about what you will buy within an asset class. You can find smallcaps losing while bluechips perform; telecom losing while tech stocks win; HDFC Bank stock going up, while YES Bank goes down. What you hold within equity dictates how much money you make.

Expertise in timing and selectivity need knowledge, skill and attitude, acquired and honed over market cycles. There are others who will manage your money, proposing that they have these skills and you can pay to draw the benefits. What are your choices?

Consider a matrix with four choices: Passive timing and selectivity; Passive timing and active selectivity; Active timing and passive selectivity; Active timing and active selectivity.

All four choices are available to investors, with varying costs, risks, returns and performance history. You can choose to remain fully passive. There is tremendous merit in that choice. You understand timing is tricky; that forecasting the future is not easy. However, you understand the merits of asset allocation and diversification.

You choose a strategic asset allocation— say 40% of your wealth is in equity. You stick to this proportion, review annually and rebalance. Passive timing doesn’t worry about markets or cycles. For selectivity, you choose passive again. Buy the indices. You make a return that mirrors the market. You can buy a mix of large-, mid- and small-cap indices, using low cost ETFs. You do not take an active call on which sector, which stock, and which fund. You are content with the market index that holds a representative set of stocks. You know that someone is making more money than you, but you don’t want to lose money trying to chase that rainbow.

This approach should be perfect for people who do not have the time, energy and interest in investments, but still want their money to earn a decent return. There is no drama here —just immense wisdom that average returns are the best case returns and low level of investment activity is good.

The problem is no one will “sell” this strategy to you. No one who earns their living by managing other people’s money can make any money out of this strategy. Portfolio managers, fund managers, investment advisers and distributors will not push for this simple approach. Why so?

The active investment management industry is built on the premise that above average return can be earned by someone who professionally manages timing and selectivity. The mutual fund industry showcases how returns on its products are better that of the index.

Beating the index and earning a fee for doing so is the business of active fund managers.

Investment managers primarily focus on selectivity. They modify portfolios to underweight sectors that aren’t doing well; they choose stocks they expect to perform, dropping those that don’t. They don’t hold the same index stocks, in the same proportions, but actively manage what they hold. They hope to do better than the index in the process.

Do they deliver results? Yes. Every year, the league tables features funds that have beaten the index; and funds that have underperformed the index. But the list of funds that win is not a fixed set of names. A different fund wins each year. Typically, investors chase that fund, after the act, in the hope of riding a winner.

On an average, however, if one bunches up all the funds, the good and bad performers cancel out one another, and we are left with index returns. That does not mean active fund management is wasteful—it just opens up the avenue for another level of work: fund selectivity.

If you choose passive timing and active selection, you can manage your 40% in equity by selecting a bunch of funds or portfolios or stocks to deliver returns. There is a risk but there is also a reward if you selected right. You can lean on advisers to select funds for you. Many distributors earn a fee for selecting funds, leaving you to manage the asset allocation and timing. Since they earn commissions from funds for selling, this activity has come under criticism.

What if you want active timing and passive selection? This is the job of the adviser. The professionals who know your needs, goals, and preferences and know about market cycles and macroeconomics. They will manage your asset allocation and protect your money; and they will implement the strategy using low cost index funds. We don’t have this useful category – no one pays them, and no one showcases the value this holds for the investor.

If you choose active timing and active selection, there is general chaos in that space. Many funds have products that offer both timing and selectivity. Fee-only advisers do it too, but we don’t pay them enough. A performance linked fee for the assets under advice is a reform that has sadly not happened.

Make your choice with the matrix we discussed. If your time and energy is devoted to earning money, choose passive; if you have an adviser you can trust, lean on them for fund selection. If you want to time the market and select what you believe are funds and stocks that will win, go ahead, it is your money! Just be sure you know what you are doing and who is accountable for the outcomes.