Passive Index fund VS Evidence-Based investing - what is the difference and what is better?


Passive Index fund VS Evidence-Based investing - what is the difference and what is better?

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3 minute read

The world of investment can be an intimidating place for the inexperienced.

Investment is an intricate area of finance that has its own set of rules and technical jargon and these combined can make it an inaccessible place for the average person.

If you have done your research and considered investing in a portfolio, you will inevitably have discovered an abundance of experts declaring the virtues of different investment approaches. One will promise you long-term stable growth, adopting a passive investment strategy; another urging you to reap greater rewards via active investment. Others may claim that only an evidence-based process can trump all other options.

For a novice, however, what do these different options mean? Furthermore, which claims are credible?

Words and Meanings

This blog will focus on the significant differences between passive and evidence-based investing. The differences are material.

Active VS Passive Investing

In order to appreciate the distinctions between passive and evidence-based, it helps to first fully understand the difference between both passive and active strategies.

Passive or Index investment is a long-term, ‘buy-and-hold’ approach. This approach endeavours to constrain risk in a portfolio, whilst minimising costs. A typical passive strategy is what is known as an index fund. These approaches utilise financial market indices as the basis for compiling an investment portfolio. An index fund takes major indices and holds stakes in the assets listed, weighted according to each holding.

An index fund makes intermittent changes to the holdings. For example, if one company drops out of the index, it is sold and an investment is made into a replacement.

Index funds only necessitate limited management and are also economical to run. As an investor, you can gain returns proximal to the index; only deducing modest costs. This is the reason why these are intended as a long-standing investment option.

Active investment management encompasses numerous active parts; top-down or bottom-up; value versus growth; sector versus sector; macro or micro viewpoints; buying and selling; stock-picking and market timing.

Rather than monitoring market movements, an active fund manager seeks to win. There is immense pressure to be bigger, better and faster. Tiny pieces of information can be critical in this fast-paced world of stockbrokers, fund managers and discretionary investment managers, known as the City.

All the decisions and moving parts, however, come at a cost to you, the investor. After all, the fund manager still needs to be rewarded after all other costs are deducted.

In the U.K. alone there are in excess of 90 firms of discretionary investment managers. These firms are desperately vying for your hard-earned money to invest and all of whom claim their strategy is the winning one. How can one ascertain which is the winning one?

Passive Investing VS Evidence-Based Investing

For many investors, the internet is your primary source of knowledge around investment, yet it is challenging to be able to understand the visible differences between passive and evidence-based investing. Many articles blur the edges.

Evidence-based investing takes a long-term stance and is systematic in its approach. It is, in essence, based on academic evidence that markets will perform efficiently over time.

Evidence-based strategies are not content to ‘ride with the market’ and accept whatever return it delivers. Evidence-based investing seeks to explore and understand the profound causes of why markets deliver growth long-term. This approach looks at what causes the exceptions. Fund managers build portfolios abiding by predetermined models, following defined rules for growth. These approaches are not dependent upon market fluctuations.

Evidence-based investing is a synthesis of the strengths of both passive and active strategies. An evidence-based approach involves prudently choosing assets to include, rather than blindly following an index. This strategy does not rely on subjective judgements and speculation. Evidence-based portfolios are compiled according to defined and systematic rules which are established to enhance returns, whilst minimising risk and cost.

Some evidence-based investment strategies, also known as Smart-Beta funds are customised versions of index funds. Smart-Betas are based on market indices but do not follow market-cap weightings. Instead, they focus on alternate metrics such as sales or earnings growth, profits, stock momentum etc.

Based on renowned rules, evidence-based portfolios choose only those assets which fulfil their criteria. Smart-Beta funds aim to exceed overall market performance by simply acting to be more selective in the manner in which they construct their portfolios.

Dissimilar to active funds, Smart-Beta funds do not require consistent monitoring in order to buy and sell at the most favourable times. Ultimately, once set up, these can autonomously track the selected metrics, just as a passive fund tracks the market cap weighting of an index.

Evidence-based approaches like Smart-Beta aim to accomplish the perfect synergy of minimal cost and risk, accompanied by an above-market average return, over an intermediate to long term investment period.

Would you benefit from having your investment options explained to you in greater detail, on a personal one-to-one basis? Our team of investment consultants would be delighted to give you a personal tour through the complex and daunting world of investment. Our experts can navigate your aspirations and your concerns, all directed to your personal circumstances. Get in touch with us today.

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