If you’re new to investing, you may have heard of the terms ‘active’ and ‘passive’ being tossed around. But what do these terms really mean? In the first blog in this ‘Key finance terms’ series, we help to deconstruct these concepts which you may come across when embarking on your finance journey.
Active investing is performed by portfolio managers who aim to beat the market in the short-term. Generally, these active managers believe markets are inefficient, and that they can do better. Hence, active managers try to choose the most attractive investments that boost their portfolio returns. The difference in returns between active portfolios and the benchmark portfolio is referred to as alpha. To invest in active portfolios, investors typically place their money in mutual or hedge funds. Active managers often accept greater risk in exchange for higher alpha, implying their portfolios tend to perform better when the market is more volatile. Outperformance requires extensive research and is contingent on the skill of the managers who oversee your portfolios, therefore active funds require high management fees from investors.
Passive investing occurs when an investor places their funds in a portfolio that aims to track the performance of a market index. These investors typically believe the market can achieve the most optimal risk-return tradeoff in the long-run. Thus, by replicating the risk characteristics and security holdings of a certain benchmark, a passive investor can essentially ‘hold the market’. A passive investment product which has gained popularity in recent years is Exchange-Traded Funds (take a listen of F3 founder Camilla Love’s take on ETFs in her podcasts with MoneyMade Simple and Shares for Beginners!), which tracks an index such as the S&P500 or the ASX200. The extent to which a portfolio or stock tracks the market is referred to as its beta. Since passive investing does not require a lengthy process of research and assessment of individual securities, fees charged are typically much lower. Further, less buying and selling activity means capital gains tax charged on these portfolios also tend to be lower.
Hopefully this blog has clarified some key terms you may have come across in finance. Stay tuned for our upcoming pieces!
Disclaimer: The intent of this blog is to provide careers advice, not financial advice. It does not take into account individual circumstances. For financial advice, please see a financial adviser.
