How is passive investing different from active investments and do passive strategies really add value to investments?

We often look at active and passive investing as two distinct strategies but these are more of allocations that you need to make in different proportions. More than seeing active investing and passive investing as competitive strategies, it is essential to understand when active investing works and when passive works better? Here are 5 ways to understand when passive investing can actually add value.

· In the last 10 years since the financial crisis, global hedge fund managers have been finding it extremely difficult to beat the markets. When you find that the ratio of fund managers beating the index is falling, it is a signal to shift to passive investing. After all, why to pay those fancy fees to hedge fund managers when they cannot give that much sought after alpha.

· Is it a market that is driven by macros or by micros? An active approach is basically a stock selection approach and it works only when the micros trump the macros. When most markets were being driven by global systemic factors then passive funds will actually outperform active funds, net of all costs. That is again a case for passive shift.

· What you do when valuations are above historical averages. If the valuations are well above the historically average P/E and if there is limited earnings visibility, then again it is a case for passive investing over active investing. In such situations, stock selection is going to get awfully harder and you are better off keeping your equity exposures restricted to index funds. Costs will again matter in this case.

· Is the spread between active and passive fund returns consistently narrowing? If that spread is consistently narrowing then it means that active fund managers are increasingly finding it difficult to identify and play on alpha. In other words, active fund managers cannot compensate you sufficiently for the additional risk that you are being asked to take on. That is a clear indication for you to go ahead and shift to passive funds.

· Finally, look at the cost differentials. In India, the difference is about 1.25%. Fortunately, most active funds have been able to generate much more than that so the active investing logic has held on. As an active investor you always need compensation for the higher fees and the higher risk in the form of higher returns. Fees are a very important component of your total returns. You shift to passive investing like in the case of index funds and ETFs to save big time on fees over a period of time. Vanguard, which is a pioneer in index funds, has saved close to $1 trillion for investors over the years purely through lower fees. That explains why the two biggest fund houses in the world today (Blackrock and Vanguard) are passive funds; and manage over $11 trillion between them.