ETF: Passive Investing vs Active Investing
We know that ETFs are in fact mutual funds that can be traded like stocks. This ultimately brings us to one question – which style of trading should you choose? Should you buy ETFs and adopt a passive approach or should you manage your ETF portfolio actively? Or perhaps, you might also be thinking of something in between. This chapter will go into the pros and cons of passive and active investing, just to provide new investors with a flavor of what to expect in both scenarios.
Why Active Investing – A majority of traders and investors today prefer to take the route of active investing. This means consistently tweaking your portfolio in an attempt to beat the benchmark return. For that reason, most mutual funds are actively managed by their respective fund managers. For retail traders, active investing will mean higher frequency of buying and selling ETFs to lock in short term gains in an attempt to beat benchmark returns. When a retail investors actively invest an ETF, he might need to include strategies such as sector rotation, short selling and buying on leverage.
Why Passive Investing – On the other hand, investors and managers of passively managed funds believe that the market is indeed efficient and that ultimately, there is no point in trying to beat it. This is also why these managers do not try to craft a system to beat the market but spend their time trying to mimic their portfolio so that it tracks the benchmark return as closely as possible. For retail investors, passive investing simply means buying an ETF and holding it long term. Passive investors ignore short term market volatilities and choose, instead, to focus on the long term profitability.
Ultimately, choosing to passively invest in an ETF is different from choosing to passively invest in a mutual fund, simply because mutual funds are actively managed by fund managers and ETFs are not.
The main advantage of actively trading ETF, intraday or short term buy/sell is that one might be able to outperform the market if he is very knowledgeable and disciplined. If an experienced investor believes that the market is due for a downturn, he might exit his position and opt for a short selling strategy. This is somethings that cannot be achieved by passive investing. The downside is the higher cost incurred from high frequency trading. Each buy/sell you perform will incur a commission charge.
Passive investing in ETFs has its advantages as well. It does not require too much decision making and has a lower maintenance and operational cost. If you passively manage the ETF, there is still a chance that you might outperform the market, depending on which index you are buying and which benchmark you are comparing it with. However, you will be subjected to the elements of the market and this means going down when the market goes down.
As we have mentioned before, it ultimately boils down to the type of investing lifestyle and philosophy you want to base your strategies upon. The best strategy is the one that suits your trading or investing plans and can assist in reaching your success goals in the market.