Active Versus Passive Investment

Active investment is an investing strategy where investors try to actively pick stocks with an objective of generating superior returns by trying to beat the index or benchmark. Here the idea is to chase the return, without much worrying about risks.

Active investing is a strategy where investors try to beat a market or appropriate benchmark which is called as generating an alpha – α. Active investors rely on speculation about short-term future market movements and ignore the overall market wisdom. They commonly engage in picking stocks, times, managers, or investment styles. Active investors who claim the ability to outperform a market are in essence claiming to accurately predict the future. When accurately measured, this is simply not possible. Surprisingly, the analytical techniques that active investors use are best described as qualitative or speculative, largely including predictions of future movements of stocks or the stock market.

Passive Investment is an investing strategy that tracks an index or a portfolio created based on pre-defined set of rules. The idea is to avoid the adverse consequences of failing to correctly anticipate the future.

There is sharp contrast between the behaviour of passive and active investment. Passive investors don’t try to pick stocks, times, managers, or styles. Instead, they buy and hold diversified index based passively managed portfolios and enjoy risk adjusted market returns known as beta – β. The term “passive” translates into less trading of the fund’s portfolio, more favourable tax consequences, and lower fees and expenses than actively managed funds.

~: Major differences :~


~: Active Investment – Problems :~

Basic premise of active investing is to generate superior returns and beat the index or a benchmark.

Generation of superior returns greatly depends on,

  • how efficiently active investors are predicting the future,
  • how efficiently they are able to act upon information,
  • how are they interpreting the news,
  • how many variable factors they are able to foresee & interpret those factors &
  • how much skilful are they in doing these activities.

Largely there are five challenges of active investment. Let us dwell little bit more on each of these problems

Prediction Risk

To generate the alpha, it is very essential for any active investor to accurately predict the future of a stock or a market. The superior returns are directly proportional to effectiveness of efficiently predicting future prices.

There are various methods of predicting the future prices. Some of which are; analysing past performance, fundamental &/or technical analysis, few people also look at astronomical charts to predict the future price movements. However, if there is any accurate model which can accurately predict the future, all the investors in this world would have been wealthy.

In 1965, MIT Professor of Economics Paul Samuelson published a paper, “Proof that Properly Anticipated Prices Fluctuate Randomly,”. His findings can be summarized as: 1) market prices are the best estimates of value; 2) price changes follow random patterns; and 3) future news and stock prices are unpredictable. There are many other numerous research papers available on how much it is difficult to predict the future prices.

Let’s do a small experiment as a proof – In below mentioned data we have considered 50 companies that are forming part of Nifty 50 Index as on March 31, 2016. Out of these 50 companies, there are 43 companies for which prices are available since April 1, 2006. We have calculated financial year returns of each of these companies. Figure mentioned in “()” are % returns for a financial year. Figure mentioned without “()” is rank of that company based on return of that particular FY. E.g. Bharti Airtail in FY 06 – 07 gave a return of 81% which was highest in that year so is ranked 1, in FY 07 – 08 it gave 13% & was ranked 13th, in FY 08 – 09 -22% & was ranked 17th.

Let us look at returns & ranks of all these 43 companies from FY 06-07 to FY 14- 15 & try to PREDICT the winners of FY 15 -16.

How many of us accurately predicted winners of FY 15 -16?

If predicting future winners is difficult, out of just 43 companies and with only one evaluation parameter of past performance, how can one predict future winners from around 5000 listed companies on Indian stock exchanges? It is just like looking for a needle in big hay.

Market Efficiency

Whenever we say “Market“, a picture of BSE building comes to our mind, right? But is BSE or NSE building a market? These are just a physical place where people meet (physically or virtually) to buy or sell.

Market in its true meaning is a mechanism where information is continuously flowing & processed. Its like a big brain processing information on continuous basis, day and night, twenty four by seven. People react to such information and set the prices.

To generate superior returns, one should be able to get the new information before it hit market. In addition to getting new information in advance, one should also be able to correctly interpret it and make the move. In current environment, where information is efficiently flowing at a lighting speed due to technological advancement, practically no one can claim that s/he is having first hand information. Once new information is in market, everyone reacts to it and accordingly prices start moving up or down. There are lakhs & crores of investors who continuously process new information and efficiently adjust the prices by way of making quotes. The real value of information is quickly and efficiently get discounted in the prices. In practice it is impossible for a single investor to beat the collective winsome of market. If someone is claiming to have first hand information or news, s/he is simply either making fool of her/himself or fooling other investors.

In summary, the efficient market hypothesis (EMH) is an investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.

Subjectivity

Let us consider small example for understanding subjectivity. Assume that there is a pot full of gold and big hey is kept in front of you and you are asked to choose one of it. Any rational human on this earth will obviously choose pot full of gold. Now let us assume, a cow need to make a choice. Will she choose pot of gold ? Obviously, no. Dose that mean that gold does not have any value? Defiantly No, but cow will see more value in hay and will accordingly make the choice. Similar, as you will see more value in Gold you will choose pot full of gold. This is mainly due to subjective opinion which varies from person to person.

Subjectivity refers to how someone’s judgement is shaped by personal opinions and feelings instead of outside influences.

Let us take one more example. There is a house which is up for sale & is very near to railway station. There will be some buyers who will give good price of that house because it is very convenient for travelling. However, there will be few other buyers who will not give similar value to the same house, saying that there will be too much noice & disturbance. Both buyers are right in their own opinion.

In investment world also subjectivity plays a critical role. Investment decisions are made based on subjective opinion an investor has  formed. There can be various reasons for forming an opinion.

For every buyer there is a equivalent seller. Trades take place only when buy & seller agree to single price. At the time of making decision buyer & seller both assumes that they are making right decision. However who is correct will be known only in future.

Physical v/s Social Science

Suppose, you want to construct a house. With the help of engineers, you can exactly calculate how much materiel (i.e. sand, cement, bricks, steel, water etc.) will be required. It is very easy to predict the outcome of proper mixture of these material for constructing a building. You know for sure that, in what ratio water and cement should be mixed to get strength and the expected result.

  • Will steel change its behaviour if RBI changes its rate?
  • Will water not freeze at zero degree because there is change in government?
  • Will electricity not pass through copper if there is a scam in copper manufacturing company?

No, we know that this will not happen, because steel, water and electricity has physical properties which do not change.

It is very easy to predict the outcome of anything which has physical properties and which does not change irrationally. On the other hand, it is challenging to predict outcome of human behaviour which is part of social science.

Change in price is mainly dependent on human behaviour & there is no clear formula to predict human behaviour. People may or many not behave similarly in similar situations.

Let us assume that a good annalist met with company management, thoroughly checked and analysed its financials, met with vendors and customers to take their opinion and have done all due diligence before coming out with a report which states its estimated future price with all the justifications. However, it is quite possible that he may still go wrong on his estimation due to sudden change in government policy. Further, market in totality has to agree to his estimation for effectively capturing the benefits.

Because of inconsistency of human behaviour, which is the main factor influencing future out come, it is difficult to predict future price movements.

Luck v/s Skill

Skill is an ability and capacity acquired through deliberate, systematic, and sustained effort to smoothly and adaptively carry out complex activities or job functions

Luck is success or failure apparently brought by chance rather than through one’s own actions.

In case of skill, results are fairly consistent; outcome of action is predictable with good level of certainty and low deviation.

In case of luck, result is random, it is difficult to predict the outcome and there are high deviations in results.

Let us understand this with examples.

Suppose you have boarded a flight. You sit and buckle your seat belt. Flight captain make an announcement – “Greetings from flight captain and welcome on board. Weather is good. We will be flying in another ten minutes. Sit back, relax and enjoy your flight. Generally we fly well, but sometime we underperformed and crash land the flight”

How will you react?

Let us take one more example. There is a patient lying on a bed before heart surgery. A heart surgeon come and says – “Hello. I am going to operate you today. Do not worry, just relax, you will be perfectly all right after the surgery. I have done around thousand surgeries so far and generally everything goes well however some time I underperform and my patient die.”

Will that patient go for a surgery?

We know, flight captain and heart surgeon have acquired skill to perform their respective duties. We can fairly predict the outcome with 99.99% accuracy. Their result will not be too volatile and will be consistent. Of course, there is still a chance of 0.01% failure due to change in some conditions which depend on luck. Such professionals are largely dependent on their own actions and very less on external factors.

In case of professions like stock picking and fund management result is mostly random and less predictable with high deviation. Same person may pick a hot stock and also may go totally wrong on another pick. Stock pickers and fund managers are not only dependent on their own actions but also on external factors. In such profession dependency on luck is far more important than skill.

~: Why Passive Investment? :~

In finance, investment refers to acquisition of any financial product with an intention to either generate income by way of interest / dividend or to generate favourable returns by way of appreciation.

Return is the function of risk. More risks more returns and vice-versa.

But does that mean if a great batsmen play without a helmet, it will help in scoring a century? Similarly, As an investor, we have to decide how much risk is appropriate to take and what risk premium we can expect by taking such risk.

Risks are of two types. Systematic Risk and unsystematic Risk.

Systematic risk, also known as “market risk” is the uncertainty inherent to the entire market or entire market segment. War, recession, inflation, regulatory framework etc. are considered to be as systematic risks. Such risks are uncontrollable risks and no one can do anything about it.

Unsystematic risk, also known as “company specific risk” is the type of uncertainty that comes with the company or industry. Frauds, management change, product related issues etc. are considered to be as unsystematic risks. Such risks are controllable risks.

Generating return is not in investors’ hand, but controlling risk is. Passive investment helps investors in eliminating unsystematic risk and there by capturing the premium (returns) for taking systematic risks.

~: Advantages of passive Investment :~

 It is humanly not possible to beat the entire market on consistent basis. In such case, investors are better off with taking advantage of flowing with the market and not try to ride against the current. In essence, by adopting passive investment approach, investors are recruiting entire market to be their fund manager. Passive investment helps investors in,

  • Investing in entire market at a very low cost,
  • Eliminating unsystematic risk and capturing premium for systematic risk taken,
  • Diversifying assets
  • Taking benefits of market opinion instead of relying on a particular fund manger.

 

Low Cost

No one can control the markets. But investors can control what they pay to invest.

In general, passive funds (Index Fund and ETFs) are less costly as compared to actively managed funds.

Unlike, actively managed funds, where AMCs / fund houses need to incur high salary cost of funds managers, in passive funds, they just need to replicate the indices, which is possible at very low cost.

In addition to fund manager’s cost, they also need to incur cost on researching stocks, which is not the case with passively managed funds.

Low cost, in long run benefits the investors.

Let us take an example of Rs. 1 Lakh invested which is expected to grow at 15% per annum for 15 Years.

In such case, if the expense ratio charged to the fund is 1.50% (which is a normal case for actively managed funds) after 15 years Rs. 1 Lakh will grow to Rs. 6.68 Lakh compounded at 15% per annum.

In case, if expense ratio is zero, same amount will grow to Rs. 8.14 Lakh. That is a difference of Rs.  1.46 Lakh

On an average Index Funds are charged at around 0.50% on annual basis. In which case Rs. 1 Lakh will grow to Rs. 7.62 Lakhs.

The average expense ratio of ETFs in India is around 0.25%, which will help investors get additional return of Rs. 1.19 Lakh over actively managed fund which is charged at 1.50% per annum.

There are few Nifty 50 based ETFs which are available at as low as 0.05% of the cost.

Risk Control

Risks are of two types. Systematic Risk and unsystematic Risk.

Systematic risk, also known as “market risk” is the uncertainty inherent to the entire market or entire market segment. War, recession, inflation, regulatory framework etc. are considered to be as systematic risks. Such risks are uncontrollable risks and no one can do anything about it.

Unsystematic risk, also known as “company specific risk” is the type of uncertainty that comes with the company or industry. Frauds, management change, product related issues etc. are considered to be as unsystematic risks. Such risks are controllable risks.

Generating return is not in investors’ hand, but controlling risk is. Passive investment helps investors in eliminating unsystematic risk and there by capturing the premium (returns) for taking systematic risks

Diversification

We are well aware that, we should not put all our eggs in one basket and should diversify.

Any index, is a basket of well diversified portfolio of stocks.

Index is constructed based on predefined rules defined by index service providers.

Companies are selected based on these rules without any human intervention.

Passive investment, helps in diversifying the risk associate with specific company or sector and at the same time, eliminating risk associated with human biased.

E.g. The Nifty 50 is a well diversified 50 companies index accounting for 13 sectors of the economy. Index represents about 65% of the free float market capitalisation of the stocks listed on NSE as on March 31, 2016, i.e. if someone invest in Nifty 50 index, essentially s/he is taking 65% exposure to Indian economy via equity as an asset class. Companies are selected based on criteria like market capitalisation, liquidity etc without any human intervention.

Similarly, S&P BSE 500 Index, represents more than 95% of the total market. Investor investing in a fund which tracks S&P BSE 500 Index, is essentially investing in 500 companies, which are decided by the market forces.

Such rule base portfolio creation helps in eliminating human biased as very low cost.

Market Wisdom

If one asks a large enough number of people to guess the number of green jelly beans in a jar, the averaged answer is likely to be very close to the correct number. Occasionally someone may guess closer to the true number. But as you repeat the experiment, the same person never is better every time – the crowd or a market is smarter than any individual.

Similarly, in (a jar of) stock market there are close to 4000 stocks (jelly beans). Whole market put together can take best estimate of next multibeggar stocks (green jelly beans) as compared to individual who try to forecast or predict the outcome. To repeat, the crowd or a market is smarter than any individual at predicting the future.

It may be counterintuitive. But groups of people are scientifically proven to be more intelligent than their smartest members in answering questions, problem-solving and even foretelling the future. The most famous example of this is the county fair game in which you guess a cow’s weight and win a prize for coming the closest. Guesses from all the players span a wide range by hundreds of pounds. But the average of all the guesses come very close the cow’s actual weight. This amazing phenomenon has been observed repeatedly in many experiments from county fairs to the stock market

Investors may like to look at Index Funds or ETFs for their passive investment.