Active vs Passive Investing

April 2022

Generally, there are two types of investing: active and passive. Both have their advantages and disadvantages, and it is important for each investor to understand which type of investing suits them best.

Active Investing

Active investing is more hands-on and requires tactical asset allocation, security selection, periodic rebalancing, and other portfolio management functions by a professional portfolio manager. The goal of active investing is to beat the stock market’s average returns. Active investing requires a much deeper understanding of financial markets, quantitative finance, and more sophisticated financial analysis.

Since it is hands-on, active investors must frequently manage their portfolios as a response to various micro and macroeconomic factors. More importantly, active investors must be able to understand the exact time of when to buy and sell their assets.

Passive Investing

Passive is the hands-off approach to investing and typically invests in an index. The constituents and weighting are predetermined by the index and, unlike active management, limited oversight is required. Passive investors buy and sell less frequently, compared to active investors. The goal of passive investors is to make similar returns as major stock market indexes – not to beat the market over the long term.

Types of Investments

Active investors are aiming to beat the market and make excellent returns on their investment. Passive investors tend to want healthy, modest returns over the long term. Based on these goals, active and investors hold some different assets in their portfolios.

Active investors tend to hold smaller-capitalization stocks in their portfolios while passive investors would prefer to invest in large, blue chip companies. Active investors are comfortable with risk and invest in alternative investments, such as real estate and derivatives. Passive investors are more risk-neutral or risk-averse and, therefore, invest in mutual funds and passively managed exchange-traded funds (ETFs) tied to indices such as the S&P 500.

Pros and Cons of Each

Pros: Active Investing

  • Customization: An investor is able to specifically pick and select stocks that they believe will make positive returns. Investors do not have the ability to pick and choose which stocks are in an index fund.
  • Hedging: Active investors are able to make short positions or put options to reduce the overall risk of their portfolio. Passive investors are also able to hedge, but it would require more hands-on investing.

Cons: Active Investing

  • Expensive: Hiring an active investor to manage a portfolio is expensive because of the fees. For example, 2/20 fee structure is standard in the hedge fund industry where 2% is a management fee and 20% is a performance fee. Over time, these fees can add up and cut into the overall returns of the portfolio.
  • Risk: Active investors aim to beat the market but at the expense of greater risk. Historically, the majority of active managers do not beat the market over the long term.

Pros: Passive Investing

  • Low fees: Passive investors limit the number of times they buy and sell assets. Because of this, passive investors have lower investment costs over time. Furthermore, index funds have significantly lower management fees, as compared to active management firms.
  • Taxes: Since passive investors have a long-term investment horizon, there is less capital gains tax per year.

Cons: Passive Investing

  • Lack of Customization: Passive investors do not have the option to customize their portfolios, as much as active investors. There are a limited number of index funds, and the underlying equities that make up the index fund are predetermined.
  • Smaller returns: Passive investments try to track the market, not necessarily beat. Active managers are aiming for large returns

Value vs Growth Investing

April 2022

Value versus growth investing are two different styles of investing. Value investing is based on finding undervalued “cheap” stocks while growth investing is based on finding stocks that have a significant runway for growth ahead.

Growth stocks are typically overvalued by market participants based on multiples and fundamental analysis, but this is because investors believe that the company will exponentially grow over time and generate better than average earnings and profits. Value stocks are often more established corporations while growth stocks are younger companies that can be big or small. Since value stocks are traditionally more established, it is not uncommon to see value stocks with high dividend yields.

Since value stocks are undervalued, investors will buy the stock with the expectations that the stock price will eventually rise and reflect the fundamentals. These stocks are not very volatile and therefore lower risk but at the expense of yielding lower returns, as compared to growth stocks. However, care must be taken to ensure that the stock is not cheap for a reason.

Growth stocks are companies that show impressive growth in earnings and revenue. These companies are expanding quickly, and this becomes very attractive for investors. Since they are growing quickly and there is much media hype, the multiples, such as P/E or EPS, are very high which would mean that these stocks are overvalued. However, just because the multiples indicate that the stock is overvalued does not mean that the stock will not continue to rise. Investors believe that these growth stocks can continue to grow quarter over quarter. These stocks are traditionally more volatile and therefore more risky but with the potential of impressive returns.

Investors do not have to choose between value investing and growth investing. There can be some overlap in a portfolio, but it boils down to the investors risk tolerance and personal preferences.

What is Factor Investing?

April 2022

Factor investing is a method to select stocks based on certain factors, such as value, size, volatility, momentum, and quality. These are called the style factors. There are also macroeconomic factors, such as interest rates, inflation, and economic growth. Investors use these factors in order to determine which stocks to invest in. Factor investors use this research method to find value stocks that can help a portfolio beat the average market returns.

Generally, factor investing is based on five principles for screening.

“Undervalued stocks beat overvalued stocks.” Factor investors can determine if a stock is undervalued by certain multiples, such as price-to-earnings ratio and price-to-sales ratio. Factor investors believe that a value stock is more valuable than a growth stock.

“Small companies beat big companies.” The size principle states that a small-cap company is more likely to generate higher returns than a large-cap stock.

“Stocks that have positive momentum will continue to increase in price.” Momentum principle is the idea that a stock that has beaten the market historically within the past year is likely to continue with that upward trend into the future.

“Low volatility is better than high volatility.” Factor investors also believe that low volatility stocks produce better risk-adjusted returns than high volatility stocks.

“Higher returns on capital are better than lower returns on capital.” Companies that have lower debt or have assets that grow in value have better fundamentals.

Factor investors use these principles to stress test potential investments. Those stocks are further tested in relation to macroeconomic factors, such as how interest rates, inflation, and GDP impact the stock or asset class.

Investors can use these principles to screen their own potential investments. Since factor investing has gained popularity, there are now ETFs built around factor investing principles.

What Are Market Cycles & Why Does It Matter?

April 2022

Market cycles are periods of patterns and trends in the stock market that can impact industries and asset classes differently. There are various causes for market cycles, such as new groundbreaking innovations, change in government administrations, or change in interest rates.

Market cycles are important because they impact how some investments react. Some stocks or asset classes may perform better in one cycle than another. Because of this, many investors have different strategies to maximize returns during specific market cycles.

There is no specific time frame for a market cycle. For long-term investors, a market cycle can be 2-4 years while a swing trader may view changes in market cycles from week-to-week.

There are four phases of a market cycle.

  • The accumulation phase is when the market reaches a bottom and investors begin to buy again.
  • The markup phase is when the markets are stable and prices increase.
  • Distribution phase is when investors begin to sell and the market reaches a peak.
  • Downtrend phase is when stock prices fall.

Investors are always looking for the accumulation phase of a market cycle because that is when prices are low, and some stocks may be undervalued. Investors always try to buy low and sell high. Investors who are trying to maximize returns are also trying to time the distribution phase where prices are at a peak.

The smart investors are always looking for market cycles within the stock market, bond market, and the economy in order to take advantage of the four phases.

What Is Leverage & How Do You Use It?

April 2022

Leverage is an investment strategy where an investor borrows money to buy an asset. Investors do this in order to increase their exposure to an asset which can either significantly increase their returns or increase their losses.

Investors who are extremely confident in an investment may take on borrowed capital to increase their holdings in that investment. This strategy is done by professional investors who seek to increase their returns and by businesses who want to expand into a new venture.

On a balance sheet, leverage is considered a debt but one that is used to finance assets, similar to mortgage loans used to buy a home.

An investor would use leverage by simply getting a loan and using that borrowed capital to invest in various instruments, such as options. Investors can also indirectly leverage their investments with leveraged ETFs which use financial derivatives and debt to increase the returns on the underlying assets.

The most common type of leverage used is called margin. Margin is the strategy of using existing cash as collateral to increase buying power. An investor can borrow money, pay an interest on the loan, and use the borrowed capital to purchase stocks, options, etc.

Leverage is not for everyone. It can significantly increase gains if the investment’s value increases, but if the value falls, the losses are magnified. Because of this, leverage is typically only practiced by professional traders and investors who have significant experience in the financial markets.

What is Rule of 72?

April 2022

The Rule of 72 is a calculation to determine the number of years it takes to double the invested money given a specific annual rate of return. The formula shows the power of compounding interest and how it can work in favor of investors.

To determine the years to double, simply divide 72 by the annual rate of return of an investment.

Rule of 72 can be useful in determining valuable financial information. For example, if the U.S. GDP grows at an annual rate of 2.5%, it would take 28.8 years for the GDP to double in size. If the S&P 500 has an average annual rate of return of 9.8%, it would take roughly 7.35 years for your portfolio to double in value.

The rule can also show how quickly debt can add up. If an individual has credit card debt with an interest rate of 20%, their debt would double in just 3.6 years.

What is ESG Investing?

April 2022

Environmental, social, and governance (ESG) criteria are standards for a company’s operations. It is a score to determine how well a company performs as a steward of nature, its relationship with its employees and customers, and the company’s leadership. ESG investing is the act of investing in companies that adhere to these high criteria. It has become a popular type of evaluation of companies as more people are becoming socially and environmentally responsible and want their portfolios to reflect that.

Environmental (E) is the criteria to determine a company’s energy use, pollution, and conservation efforts. Many companies have environmental risks associated with their business operations, and the environmental criteria is a method to determine how that company is managing those risks and reducing their carbon footprint.

The Social (S) criteria is qualifies how a company manages relationships with its employees, customers, and suppliers. This includes pay gaps across social groups, executive compensation relative to the lowest earning employees, support for social issues such LGBTQ+, avoidance of child labor and other factors to ensure ethical supply chain.

For Governance (G), some factors are the diversity of the workforce, board and leadership team. It can also include the use of corporate resources by executives, compensation structure and the level of transparency between the shareholders, executives (agents of the shareholders), and its employees.

Many investors have begun to invest more in ESG companies, as social values and responsibilities become more important. Companies with a bad social and environmental reputation can still take significant losses, regardless of how profitable it is, such as BP in 2010 with its oil spill.

ESG investing is a relatively newer practice, but has gained popularity with many organizations ranking publicly traded companies based on their ESG scores. As a result, there are billions being invested into companies with higher ESG scores. There are ETFs that focus on ESG companies, and many mutual funds have invested more into these types of companies.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Xantos Labs does not guarantee its accuracy.

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