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Active investing versus passive investing

investing in ETF's

Written by Kaspar Huijsman | 5 minutes
WED 13-03-2019
Many of our clients are active self-investors. They want to be able to operate autonomously and make their own investment decisions. Nevertheless, the term passive investing may be appealing to you. A passive (index) investor invests in indices, normally through ETFs. An ETF stands for Exchange Traded Fund and sometimes also called trackers in the past (to track = follow). They are investment products where you buy "a bag of shares within the index" in one purchase. Its easy and the costs are low (about 0.2% on an annual basis). Moreover, almost all indices can be followed by investing in ETFs. As an active self-investor, you can invest passively as part of your portfolio.

Active investing
In addition to the ETFs, there are also investment funds that often have an active investment policy. That active policy is usually aimed at outperforming the index. An index has thus become the benchmark that must be defeated.
 Certainly in the somewhat longer term it is no easy task to beat the benchmark - after deduction of costs. Does this mean the end of actively managed investment funds? No, because there are still a number that beat the benchmark. The question is: which ones are they? And is it true that the person who has managed to beat the benchmark this year will do so again next year? Unfortunately, the answers to these questions can not be given unambiguously. But there are a number of ratios that can help in assessing return and risk.

Research shows that active fund managers (who therefore deviate from the index composition) score better on average than those fund managers who (virtually) do not deviate from the index. The higher the active share of an investment fund, the more deviates from the index that serves as a benchmark. An active share of 40% percent that 40% of the investment fund's holdings differ from the benchmark. Unfortunately, this figure is not so easy to find, but if you opt for an actively managed investment fund, do not use an "index hub" but an actively managed fund.

Sharpe ratio
The Sharpe ratio was developed by - the later Nobel Laureate - William Sharpe. With this ratio, the relationship between return and the risk that has arisen in achieving the return is examined. In formula form:

Sharpe ratio = the average return on the investment - / - risk-free interest divided by the volatility of the average return

An example:

Average return on investment = 8%
The risk-free interest rate = 1%
Mobility of the average return is 6%

(8-1) / 6 = a Sharpe ratio of 1.16

Now it may well be that another fund manager has achieved a higher absolute return but that the Sharpe ratio is nevertheless lower. This means that he has taken more risks to achieve the risk! See the following example:

Average return on investment = 11%
The risk-free interest rate = 1%
Mobility of the average return is 12%
(11-1) / 12 = a Sharpe ratio of 0.83

Tracking error
The tracking error shows the extent to which the return for the investor deviates from the return of the benchmark. With an "indexhugger" the tracking error will be very low. With an active manager with a high active share, there will probably be a higher tracking error. But that is also what you as an investor are looking for. If you want the return on the index, you can easily achieve that with an ETF.
Alpha.
The alpha is a number that indicates the added value of a fund manager. With a positive alpha, there is added value because there is an outperformance compared to the benchmark. If the alpha is negative, there is no added value from the fund manager. He is unable to outperform the benchmark.

Conclusion
As a self-investor you have to make a conscious choice whether you choose to follow an index - can easily in the form of an ETF - or if you opt for an investment fund that tries to "beat the index". That consistent beating of the index is not a simple task, but there are a number of ratios that can help you make an informed choice for an actively managed investment fund.

Author

Kaspar Huijsman

Kaspar Huijsman is the director of BinckBank in Spain & Portugal. He has been working for BinckBank for over 16 years now and founded the office in Marbella in 2006. A seasoned expert in investment, he offers seminars throughout Spain and Portugal, explaining how the platform works and how to assess the risks associated with investments.

The information in this article should not be interpreted as individual investment advice.  Although BinckBank compiles and maintains these pages from reliable sources, BinckBank cannot guarantee that the information is accurate, complete and up-to-date. Any information used from this article without prior verification or advice, is at your own risk.  We advise that you only invest in products that fit your knowledge and experience and do not invest in financial instruments where you do not understand the risks. 

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