One day, two men had a conversation over whose investment strategy was better. Guy #1 was a strong supporter of index funds, while guy #2 was a bona fide hedge fund guy. Couldn’t come to an agreement, they decided to strike a bet. Whoever had a better 10-year performance would win a whopping 1 million USD.
After 10 years, guy #1 won the bet. He won his 1 million dollars and donated the entire amount to a non-profit organization. Does this story sound familiar to you? It can be, as the story is about the famous bet made between Warren Buffett (guy 1) and Protégé Partners (guy2).
In the financial world, there are vocabularies used to describe these aforementioned investment strategies: passive investment and active investment. Passive refers to an approach when your portfolio mirrors the index, like Warren Buffet’s. Active is when you actively manage your portfolio with the goal of outperforming the index: the strategy employed by Protégé Partners.
At the end of the 10-year bet, Warren Buffets’ passive management recorded a total return of 85% and a 7.1% average annual return. Protégé Partners’ active management recorded a total return of 22% and a 2.2% average annual return. It was a clear win by the passive management strategy.
Let’s suppose the market return is 5% while my portfolio shows a 8% return. My portfolio outperformed the market by 3%. In other words, my alpha is 3%.
Active investment is a management strategy to maximize alpha. It takes specialized knowledge, top-notch trading skills, and a lot of hours to successfully manage alpha funds. Fund managers conduct intense research deep into the market to find assets with high growth potential. Once assets are selected, they closely monitor the market to catch the right moment to buy and sell those assets to maximize the excess returns. Therefore, the expertise and know-how of your fund manager are tied to your portfolio performance.
For that reason, the management fee is often very high. Not only do you pay a higher management fee, but you also share a portion of the alpha with your manager.
Let’s go back to the earlier scenario. The market return is 5% and my portfolio shows 5%. It matches the market. My beta with respect to the market is 1.0.
The goal of passive investment is to build a portfolio with a beta of 1.0 to a particular, usually broad, market index.
While getting the alpha takes a huge amount of resources, getting the beta takes relatively less effort as it mechanically follows the index of your choice.
For a better understanding, let’s talk about index funds, a form of passive investment, with an analogy of a fruit basket. There are apples, strawberries, grapes, and pomegranates. Each fruit represents a stock asset. The basket represents an index. The particular basket is called “Red Fruit Index Fund”, and it has a conglomerate of red fruits in predetermined proportions. If the Red Fruit Index is made up of 20% of red apples, 30 %of strawberries, and 50% of pomegranates, so will be the index fund. Therefore, when the index value goes up, so will the value of your index fund.
What is the advantage of putting your money into an index fund? Let’s look into the following two cases.
Case 1. I bought 10 shares of red apple stocks and the price went down the next day by 10%. I lost 10% of my capital.
Case 2. I spent the same amount to buy the Red Fruit Index. The price of red apple stock went down by 10%. However, the value of the index went up as the price of strawberries and pomegranates went up a lot. Overall, the value of my portfolio went up!
Likewise, passive investment prioritizes stability over rewards by design. Diversification is the method of choice to minimize the risk and increase portfolio stability. When diversifying one’s portfolio, it is recommended to include assets with little correlation to one other in order to reduce the overall risk
The correlation here shows how one asset behaves in relation to the other. For instance, if asset A and asset B show similar market behaviors, the two have a high correlation.
If your portfolio is comprised of assets with high correlation, they would react similarly to a given event. This results in high risk. Therefore, it is recommended to build a portfolio with assets showing a small correlation so that they would show less volatile reactions to a given event.
Now you are well-informed about the two major types of investments and their pros and cons. What do you think the method that better suits your style? We hope the post help you find your investment style.
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“How Passive Funds Trim Your Tax Bill (by Laura Saunders)”, The Wall Street Journal, Oct 21, 2016, accessed Mar 6, 2020, https://www.wsj.com/articles/how-passive-funds-trim-your-tax-bill-1476968401.
“Index Funds vs. Actively-Managed Funds (by Kent Thune)”, the balance, Oct 31, 2019, accessed Mar 6, 2020, https://www.thebalance.com/index-funds-vs-actively-managed-funds-2466445.
“Warren Buffett just won a $1 million bett—and highlighted one of the best ways to grow wealth (by Emmie Martin)”, CNBC, Jan 3, 2018, accessed Mar 6, 2020, https://www.cnbc.com/2018/01/03/why-warren-buffett-says-index-funds-are-the-best-investment.html.