With the tech tide seemingly lifting all boats this year, there has been the familiar question raised over the merits of active investing versus simply following a passive, “index-hugging” strategy.
The topic has always been subject to much debate through the years, with both approaches having pros and cons from a headline perspective. However, as with any discussion, context is important and the answer is not necessarily an absolute one, with relative and market-cycle factors also very relevant.
Passive investing is a strategy which typically tracks a market-weighted index. The concept arrived in earnest with the introduction of index funds in the 1970s and exploded in use with the development of exchange-traded funds (ETFs) in the 1990s.
Active equity strategies, by contrast, look to outperform the market by buying and selling shares that are seen as undervalued or overvalued respectively. Active managers analyse companies in the market, looking to spot winners and sidestep losers, with the goal of outperforming the index.
Supporters of passive investing strategies contend that funds that simply track an index have lower running costs and are cheaper. The claim is also that active managers are generally not able to consistently beat the market. This is a simplistic view and one that also overlooks some fairly rudimentary points.
The first is that while passive strategies have outperformed active strategies over certain periods, the opposite has also often been true. Both strategies have “ebbed and flowed” over the past 30 years.
There has been an explosion in ETFs since the Global Financial Crisis of 2007–08, but their growth has taken place mostly during the long bull market that followed, interrupted only by brief corrections such as the Covid-19 shock in 2020 and tariff tensions under US President Donald Trump. The ETF industry has yet to be tested by an extended period of volatility. By design, passive strategies simply mirror the benchmarks they track and can’t protect investors from turbulence in those market cycles.
Setting aside the issue of relative outperformance for a moment, there are also a number of profound questions that need to be considered with passive strategies, both from a quantitative and qualitative perspective.
There is no “price discovery” with passive investing, which runs counter-intuitively to the whole notion of fundamental analysis. In a completely passive world, all markets would be flow-driven. Companies, whether strong or weak, would attract capital simply because they are in an index – a dynamic that can distort how markets function. This situation at its most severe is largely destructive for sharemarkets and a bad outcome all round.
Price discovery is central to how markets function and it is actually driven by active investors. Passive strategies simply mirror the market, benefiting from the research and trading of others without questioning whether securities are priced fairly. In reality, it’s the constant work of active investors, who are the agents of price discovery, weighing fundamentals, correcting mis-pricings and responding to new information, that keeps markets efficient. Without this process, passive investing would have no foundation. Passive investing is only sustainable because active investors exist to keep prices “honest”.
Financial markets exist to help efficiently allocate capital, with an intended link between a company’s fundamentals and its share price. Active investing is an essential part of this process. Passive investing strategies largely track indices that are market capitalisation-weighted. The larger the market cap, the larger a company’s weighting in the index. New companies that enter an index are also suddenly more attractive to the passive investor, despite the likelihood that the fundamentals behind the company are not likely to have changed in the space of a day. This is also while the sharemarket at its essence should be “a voyage of price discovery”.
The market-cap-weighted nature of passive investing and the ignorance of company fundamentals also can introduce substantial “momentum driven” risks. The recent surge in enthusiasm for AI illustrates this effect, with a small cluster of mega-cap companies now representing a disproportionately large share of the market’s value. By design, passive strategies allocate more to these giants as they grow, regardless of whether their fundamentals justify it – a trend that risks creating imbalances over time.
The “Magnificent Seven” is a well-known moniker, but chip-maker Broadcom is another super-cap tech company valued at over US$1 trillion ($1.7t). As an aside, the ninth company in the US$1 trillion club is Berkshire Hathaway, the conglomerate managed by active investing supremo Warren Buffett.
In any event, the top eight tech behemoths are worth more than US$20t combined and account for about 35% of the S&P 500 (this is double the long-term average when looking at the weighting of the top 10 stocks in the index) and make up around one-sixth of the total value of stock markets globally. The Magnificent Seven alone now exceed the combined market capitalisation of the eight largest national sharemarkets outside the US.
While optimism around the AI boom has driven these names to tremendous heights, they will not necessarily all be winners over the longer term (as those with memories of the dot-com boom will know). By their nature, passive investors will quite literally “go with the flow” until it stops. Exposure to certain companies will only reduce when the market deems it so.
An investor with a narrow focus in a specific index strategy (around the S&P 500, for instance) will also be potentially at risk of pendulum swings as part of the normal market cycle back in favour of other investment categories and destinations. Several markets in Asia and Europe have started outperforming the S&P 500 in recent months, while in the US, smaller-cap stocks (which are arguably more tied to the real economy) have risen into the ascendancy since April. The Russell 2000 index has risen nearly 40% in that time.
By their nature, passive investors drive using the rear-view mirror, while active ones try to look forward and at all available perspectives. Passive investing effectively removes the art of fundamental analysis and the prospect of “beating the market” through astute analysis. It is true that “the trend can be your friend” – but only until it grinds to a halt. A major downfall of passive investing is that you are at the mercy of total market risk.
At first glance, the costs of active management may be slightly higher, but there are also costs (implicit and explicit) to consider. Passive investors are trying to achieve market returns, but will generally fail to do so because they are charged management fees (generally up to 0.3%, but sometimes more) for looking to do so. Passive funds also incur brokerage and administration costs, not just when their benchmarks change but also when investors buy new units or redeem existing units in the fund. Given a passive manager will hold many more stocks generally than an active one, the transactional and administrative costs are often greater. Tax inefficiencies (a topic for another day) are also a factor to consider.
The notion that good research and astute stock-picking can be rewarded (and justifies a higher fee) seems logical. Successfully seeking out unloved stocks is not something that a passive investor aspires to.
Active strategies are also “active” in a much broader sense. Active fund managers can look to actively engage with companies to help deliver optimal outcomes as it relates to the interests of all stakeholders from an Environmental, Social and Governance (ESG) perspective. Passive investing typically cannot play a role in this dynamic, nor channel funds away from non-ESG-compliant businesses while rewarding those that are proactive and progressive.
Active investing also opens doors to opportunities that passive strategies simply cannot access. By actively managing portfolios, investors can participate in exclusive offerings such as initial public offerings (IPOs) and private placements, which are typically unavailable to passive funds tied to broad market indexes. These opportunities often provide early entry into high-potential companies or access to unique investment structures that can potentially deliver outsized returns.
Another common counter from passive strategy proponents is that “there is no point” trying to beat the market as, historically, many active managers underperform when taking fees into account. Indeed, many investors will roll out one of Buffet’s quotes to this effect. The “Iron Law of Costs” also means that the performance of an “average” active manager post-fees is highly likely to be under that of the market.
However, the reality is that with active managers, as with anything in life, there are good and not-so-good ones. Historically, over time, good active managers have outperformed their underlying indexes. Analysis from Schroders showed that the best active managers have added significant value/alpha when looking across 10-, 15- and 20-year periods. The top-fifth-percentile achieved 3%-4% of excess returns.
This is also evident in New Zealand as well. Looking at 10-year returns to June 30, 2025, according to Morningstar, the top three KiwiSaver growth funds are all active managers.
The benefits of an active (value-driven) investment style are also showing out in many of Generate’s funds, which have outperformed several of our passive-investing-dominated competitors.
Schroders also highlight the point made earlier that the relative tailwinds to passive investors have come in markets (particularly the US) where there is “narrow breadth”. This again goes to the concentration risks that many passive investors are riding.
There is an old saying that goes: “When the tide goes out, you can see who is swimming naked.” The question going forward may be whether some receding market and/or sector tides re-expose the wider defects of a passive investing style and again reinforce the credentials of active investing strategies.
Generate is a New Zealand-owned KiwiSaver and Managed Fund provider managing over $8 billion on behalf of more than 175,000 New Zealanders.
This article is intended for general information only and should not be considered financial advice. The views expressed are those of the author. All investments carry risk, and past performance is not indicative of future results.
To see Generate’s Financial Advice Provider Disclosure Statement or Product Disclosure Statement, go to www.generatewealth.co.nz/advertising-disclosures/. The issuer is Generate Investment Management Limited.
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