USAIn the past 10 years, only 11% of actively
managed funds had outperformed market.
EUROPEIn the past 10 years, only 6% of actively
managed funds had outperformed the market.
- shares of all companies on the market are being purchased
- the goal is to copy the performance of the market
- the risk of the investment corresponds to market risk
- strategy is to buy and hold
- minimum intervention in the portfolio
- is the more inexpensive form of investing
- specific securities are being selected
- the goal is to surpass the performance of the market (index)
- efforts to eliminate market risk
- timing of purchases and sales of financial instruments
- numerous interventions in the portfolio
- is the more expensive form of investing
Benefits of passive investing over the active
- fewer transactions = fewer fees
- lower management fees - there is no need for analytical departments
- thanks to lower costs
- eliminates the mistakes of human decision-making and emotions, which generally lead to worse performance
- more than 9 out of 10 active managers are not outperforming the market
Passive and active investing in Slovakia
We compared the performance of passive and active investment instruments in Slovakia over the last 10 years:
Index fund (ETF) which invests to global equities (db x-trackers MSCI World Index UCITSETF 1C) vs. the 3 best selling mutual funds investing to the global equities in Slovakia (Iad Global Index, Pioneer Global Select EUR and SPORO fond maximalizovaných výnosov).
Passive investing does not aim to outperform, rather simply follows the market. It works on an assumption, that by investing an individual investor has a very limited chance to earn more than the market. Low probability of higher returns approaching 0 is confirmed by the statistics on active managers of funds, according to which 89% of individual managers in the US and 94% in the Europe on average and from long-term perspective are not able to beat the market.
In order to copy the market results as accurately as possible and reach the highest possible results, passive investing operates with minimal fees.
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The investment strategy of passive investing is purchasing the entire market. Its investments have the exact composition and weight of the securities as the market. The market could be defined as a specific stock exchange or a region while the market is being composed from all the securities which are traded on the particular stock exchange or region.
How it is possible to invest in the whole market?
Tracking and buying all the securities traded on the market at the correct weight would be very difficult, maybe even impossible. Therefore, the so-called tracking and investment indices are being used. An index is a group of securities traded on the given market, which are accurately representing this market. The index can be described as a kind of market sample, its average composition. As opinion polling on a sample of people expresses the average opinion of the population, the development of the index is used to express the market development.
When, for example, we are talking about the US stock market, we are most often using the S&P 500 index, which is made up of the shares of the 500 largest US companies. Its composition seeks to take into account the size of individual sectors in the economy and as well the size of the companies to best reflect the character of the US economy. The share of individual companies in the index corresponds to their market value. The largest company not only in the US but also in the world today is Apple. Its weight in the S & P 500 is therefore the highest and corresponds to 3.9%. The second largest share of 2.9% is Microsoft, the third largest company is Amazon with 1.99%, etc.
Buying an index nowadays is extremely easy. The index always consists of securities that rank among the most traded ones on the market. Passive investing has been gaining popularity in recent years, and therefore, there are many easily available instruments for investing or copying indices, such as index funds, ETFs etc.
What is active investing?
Its basic idea is to outperform the market, so achieve higher or more stable returns. This goal is being realized via the selection of particular securities. The composition of any active portfolio differs from the market composition, therefore as well from indices.
Based on outcome of his analysis an active manager might think that the value of Amazon has more potential to increase than the value of Apple and therefore decides to allocate 5% of the portfolio to Amazon instead of Apple.
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The goal of the active investing is also to decrease the risk, mainly aim to lose less than the market in case it falls.
Today, there are hundreds of thousands of tools to invest in. There are also thousands of investment strategies, what brings an infinite number of combinations of different investment approaches and portfolios to invest and trade.
Why is then the passive investing better than active investing?
Because active investment fails to meet its goals. And that's a fact. This is evidenced by numerous statistics comparing these two forms of investment.
In the USA 89 out of 100 actively managed funds do not beat the market. In Europe, it´s 94 funds out of 100.
To get access to those 8% of funds, which offer a regular return above the market is impossible for ordinary people.
We can safely state that it is practically impossible to accurately predict the performance of financial markets on longer horizons. If someone convinces you otherwise, do not trust him. No one is capable with confidence and precision to predict the highs or lows of the markets. Statistics would have been different if that were the case.
Only very few people can invest on a way which is beating the market. It is the human factor that appears to be the burden of investing. Even the majority of professional investors can´t get rid of the maladies of human behavior in investing. Emotions and limitations of the human mindset are leading to lower returns. We have been explaining this in more detail in the under the Successful Investor Rules section.
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In general passive investing decomposes the risk more. Active portfolios tend to be concentrated, it means they invest in a limited number of securities. A passive investment always involves the purchase of a large number of securities in the amounts of thousands. Eventual loss on several instruments has a greater impact on the concentrated active portfolio than the widely diversified passive portfolio.
Another reason why they tend to have lower returns are also the higher costs of active management. Funds which are analyzing markets, economics and specific securities are in need of extensive personnel apparatus and a wide variety of tools in order to ensure its operation. Funds must pay the high salaries of analysts and managers, cover data, software, facilities costs, and so on. Such costs range from 1% to 3% per year of your investment. In case the markets grow by 10% per year any of these active funds has to earn between 11 to 13% annually to be able to achieve the performance of the market the least. Repeatedly get the most out of the market by 1-3% per annum above the market returns is a very difficult task. The fund costs however as well include entry and performance fees in most of the cases.