Episode Recap: Active vs Passive Investing: Why the Best Approach May Be Somewhere in Between

Active vs Passive Investing: Why the Best Approach May Be Somewhere in Between

For decades, investors have been presented with a seemingly simple choice.

Active or passive?

Active investing traditionally means paying a portfolio manager to research companies, identify opportunities and decide what to buy and sell.

Passive investing generally means following an index, owning the companies within it and accepting the return of that index less costs.

It’s a neat distinction.

But is it still a useful one?

On a recent episode of The Purposeful Investor, Capital Partners founder David Andrew and Aidan Wilkins spoke with Avantis Investors Chief Investment Officer Eduardo Repetto about a different way of looking at the investment landscape.

The conversation revealed an important idea: perhaps investors should spend less time debating whether an investment is labelled active or passive and more time understanding how investment decisions are actually being made.

Because behind almost every portfolio, someone or something has made a decision about what belongs in it.

Is Passive Investing Really Passive?

Consider one of the world’s best-known share market indexes: the S&P 500.

An investment fund tracking it seeks to hold approximately the same companies, in approximately the same proportions, as the index.

From the fund manager’s perspective, that’s passive. They’re following the index rather than selecting individual companies based on their own forecasts.

But take one step back.

The S&P 500 contains around 500 companies, while the broader US share market contains thousands.

So why those companies?

There are rules determining which companies qualify and an index methodology governing the portfolio.

In other words, the fund may passively replicate the index, but the index itself still represents choices about what is included and excluded.

As Repetto explains:

“The only really, really passive portfolio is the market portfolio.”

That’s a useful distinction.

Rather than thinking about investing as a binary choice between active and passive, investors can think about a spectrum of approaches, each making decisions in different ways.

The real question becomes: what is driving those decisions?

A Different Kind of Active Management

At one end of the spectrum is traditional stock picking.

A fund manager might research individual companies, meet management teams, analyse industries and make a judgement about which businesses they believe will outperform.

The portfolio might contain 20, 30 or 50 of the manager’s highest-conviction ideas.

That is one version of active management.

A systematic approach is quite different.

Rather than relying primarily on a portfolio manager’s judgement about individual companies, a systematic strategy uses data, models and predetermined processes to assess large numbers of securities consistently.

It can still deviate from the market.

But instead of saying:

“We think this company has a brilliant CEO and an exciting future,”

the process might ask:

• What does this business own?
• What does it owe?
• How much cash flow does it generate?
• How profitable is it?
• What price are investors currently being asked to pay?
• How attractive does it look relative to thousands of alternatives?

Those questions aren’t particularly glamorous.

That’s partly the point.

Systematic investing attempts to reduce the role of emotion and prediction by applying a consistent framework across the market.

A Great Company Can Still Be a Bad Investment

This was perhaps the clearest lesson from the episode.

Imagine a company with an outstanding management team.

It has very little debt, valuable assets, strong profitability and excellent cash flow.

Is it a good company?

Quite possibly.

Is it a good investment?

There’s one critical piece of information missing.

The price.

If the asking price were effectively unlimited, even the world’s greatest company would eventually become an unattractive investment.

That’s the difference between recognising a great business and identifying an attractive investment.

Repetto used a simple analogy.

Imagine buying a local café.

Before making an offer, you’d want to know what the business owns, what liabilities it has, how much revenue it generates and, ultimately, how much profit it produces.

But you still wouldn’t know whether it was a good investment until you knew the asking price.

If two cafés had similar assets, debts and profitability but one owner wanted significantly more money, the expected economics of each investment would be different.

Public share markets allow investors to make similar comparisons across thousands of listed businesses.

Prices move every day.

So do the relative opportunities.

Why Price Matters

This sounds straightforward, yet investment markets frequently tempt us to forget it.

Investors naturally gravitate towards great stories.

An exciting technology.

A transformational industry.

An exceptional CEO.

A company whose share price has risen dramatically.

But popularity and investment value aren’t the same thing.

If a company’s share price rises significantly while its underlying financial position remains unchanged, investors are simply being asked to pay more for the same assets and cash flows.

That doesn’t mean the share price must fall. Nor does it mean an expensive company can’t become even more expensive.

It simply means the price you pay is an important part of the return you can reasonably expect.

This is one reason systematic investors assess businesses holistically rather than focusing on a single characteristic such as company size, profitability or growth.

As Repetto put it during the discussion, you need to consider the company as a whole.

Diversification: Don’t Bet Everything on Your Best Idea

If you believe some businesses look more attractive than others, why not simply buy the ten most attractive?

Because investing involves uncertainty.

No model can tell you the future with certainty.

Companies change.

Unexpected events happen.

New information reaches markets.

An investment that appeared attractive yesterday can look very different tomorrow.

Diversification recognises that reality.

Instead of depending heavily on a few predictions being correct, investors can spread their exposure across many companies, industries and markets.

A systematic portfolio can potentially hold hundreds or thousands of securities while still allocating more towards companies the process determines are relatively attractive and less towards those it considers less attractive.

This distinction matters.

Diversification doesn’t mean every company has to receive the same amount of your money.

It means avoiding unnecessary dependence on any single business or small group of businesses determining your financial future.

For families investing money intended to fund decades of retirement, that difference can be significant.

How Systematic Investing Works

An investment universe can contain thousands of companies.

No analyst could realistically research every business individually and continuously update their assessment whenever prices or financial information change.

Technology makes a different approach possible.

A systematic manager can collect financial and market data across thousands of listed businesses and use consistent criteria to evaluate their relative attractiveness.

Those companies can then be ranked.

Portfolio construction models can determine where a portfolio should hold more or less than the broader market while maintaining diversification and controlling risk.

Importantly, rankings can change.

A company might look attractive when its price is low relative to its financial fundamentals.

If its share price subsequently rises dramatically without a corresponding improvement in those fundamentals, its relative attractiveness may decline.

The process can respond accordingly.

In this sense, systematic investing isn’t about discovering a handful of hidden gems.

It’s about making thousands of small, disciplined decisions consistently.

Why Costs Matter More Than They Look

Investment fees can seem small.

A fraction of one per cent hardly sounds consequential.

But costs are one of the few elements of investing that can be known with reasonable certainty.

Future market returns aren’t known.

Which country will perform best next year isn’t known.

The next winning company isn’t known.

The fee you’re being charged usually is.

And every additional dollar spent on investment costs is a dollar that isn’t compounding towards your future.

This is why low implementation costs are central to systematic investing.

Researching thousands of businesses isn’t particularly useful if the resulting strategy is so expensive to implement that much of the benefit is consumed by fees and trading expenses.

Technology, scale, tax management and trading efficiency therefore become part of the investment process rather than simply administrative considerations.

Good Investing Doesn’t Need to Look Busy

There is a persistent misconception in investing that action demonstrates expertise.

Markets move, so surely a good investment manager should constantly be making changes.

Buy this.

Sell that.

Move into cash.

Switch markets.

Find the next opportunity.

It feels proactive.

But activity and progress are not the same thing.

Sometimes the work involved in investment management results in a decision not to change anything.

Research can be conducted, an idea can be thoroughly tested and the conclusion can simply be:

the existing approach remains better.

That’s not wasted research.

It’s exactly what good research is supposed to do.

As Repetto observed:

“If you know the outcome, it’s not research.”

Real research starts with a question, tests the evidence and accepts that the answer may be no.

For long-term investors, that mindset can provide an important defence against one of investing’s greatest temptations: changing strategy simply because doing something feels better than doing nothing.

Improvement Without Constant Reinvention

None of this suggests an investment process should remain static forever.

Research evolves.

Data improves.

Technology changes.

Implementation becomes more efficient.

The challenge is distinguishing meaningful improvement from unnecessary tinkering.

Repetto compared it to improving a runner’s time.

If it currently takes someone 30 minutes to run a mile, significant improvements may come relatively quickly.

But if they’re already running close to an elite time, improvements become progressively harder to find.

A mature investment process can work similarly.

You continue searching for improvements, but the hurdle for change becomes higher because the existing process has already been extensively researched.

That’s an important principle for investors themselves.

A portfolio should change when there’s a good reason for it to change, not because enough time has passed since the last change.

Look Beyond the Active Versus Passive Debate

The active versus passive debate has encouraged investors to think in categories.

But labels can hide more than they reveal.

A better set of questions might be:

How are investment decisions made?

Are they driven by predictions or a repeatable process?

How diversified is the portfolio?

Does its success depend heavily on a handful of companies?

Does valuation matter?

Is the strategy considering what investors are paying relative to the financial characteristics of the businesses they own?

What does it cost?

And are those costs reasonable given what the strategy is seeking to achieve?

Is there evidence behind the approach?

Can the investment philosophy be explained in plain English, or does it depend on stories about predicting an unknowable future?

For purposeful investors, those questions are arguably more useful than asking whether a portfolio sits neatly in the active or passive box.

Because ultimately, successful investing isn’t about finding the most exciting strategy.

It’s about building a disciplined process that gives you the best chance of capturing long-term market returns without taking risks you don’t need to take.

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4. Key Takeaways

• Active and passive aren’t always opposites. Even index-based investing involves rules about which companies are included and how portfolios are constructed.
• Price matters. A great company isn’t automatically a great investment if investors are being asked to pay too much for its assets and earnings.
• Diversification reduces unnecessary risk. You don’t have to bet heavily on a handful of companies to pursue attractive long-term returns.
• Process beats prediction. Systematic investing uses data and consistent rules to make repeatable decisions across thousands of companies.
• Don’t confuse activity with progress. Sometimes the outcome of rigorous investment research is that nothing needs to change.