In recent times, the debate regarding the merits of active versus passive investing has escalated on the back of phenomenal inflows into ETFs (exchange-traded funds) and other low cost passive funds. But is the growing preference for passive investing justified?

Passive investing simply aims to replicate the return of the market. The prime example of the passive approach is through the use of index funds that follows one of the major indices, e.g. the S&P/ASX 200. Whereas active investing adopts a hands-on approach to outperform the market and take full advantage of price fluctuations.

US based news service Bloomberg recently reported that in the first half of 2017, flows out of active and into passive funds reached nearly $500 billion. Looking at the current landscape it’s not hard to see why, passive funds are historically known to perform well when a market is raging forward and poor in a market downturn. Passive ETFs offer low fees, simplicity and transparency while active funds are more complicated and charge higher fees for the additional analysis completed. So when passive outperforms active, it’s not hard to see why passive is currently favoured.

Secondly, when a sector begins to rally forward to the point it becomes overvalued, active funds begin trimming positions to maintain asset allocation. Passive funds, however, continue to buy pushing stock prices up higher which, on the surface, exasperates the underperformance of active funds.

The US index, as measured by the S&P500, is performing superbly since the crisis of 08’. What is concerning, however, is that much of its gains can be attributed to the funds flowing into five particular companies: Amazon, Google, Microsoft, Apple and Facebook. The majority of those funds can be traced back to “in fashion” technology-based ETFs.

This situation really supports the idea that the immense growth of passive index funds is resulting in a far more volatile and less rational market where certain stocks and sectors are being stretched to dangerous levels. This begs to ask what happens when the stock market falls and investors look to exit their position when their capital is invested in  ETFs that are over-weight in overvalued stocks that are the most susceptible to fall.

Even our own stock index, the ASX200,  shows that our market is weighted toward large, mature companies offering high payout ratios (higher dividends and less money put aside for new growth projects). A high payout ratio leaves little room for reinvesting back into the company to provide for future growth. Buying into an overvalued company that lacks the ability to grow is concerning but a passive index fund will continue to buy, as the company is part of the index.

Warren Buffet has promoted index funds and their suitability for the uninformed investor – the investor who has no interest in understanding or valuing a business. What this outlines is the appeal of ETFs as they are seen as “safe” and “easy”; in comparison to active investing which is viewed as complex and expensive. What investors fail to realise are the limitations and risks associated with index funds.

The debate of passive versus active will likely go on forever, as markets rally investors will reap the benefits of following the index as a result of lower fees and strong performance. Whereas active investors will outperform in times of uncertainty as they use discretion and analysis to avoid “losers” and pick “winners”. It is our view that active will always win out over passive in the long term as investing is a marathon, not a sprint.

At CIP Licensing Limited, our active investment philosophy allows us to position clients’ portfolios in stocks/securities that we believe have the most promise and brightest future prospects. When the market is roaring, this can sometimes result in underperformance versus the passive investing, but when the market is slow and uncertain this is when we excel. With our focus on the future, we’ve adopted this philosophy to ensure efficient growth and protection of our client’s wealth in good times and bad.

This article has been produced as general advice only, and has not taken into account your personal circumstances or financial situation. If you would like to talk about the suitability of your investments, passive or active, please contact one of our offices and set up an appointment today.