Sunday, August 19, 2012

Active and Passive investments

I am in the process of turning the articles of this blog into a logically organized e-book. Once I've worked out the kinks, it should be available to all of you (for a modest price). Yes, following the COI and ROI philosophy, I am trying to create yet another income stream.

Anyway, while compiling the postings for the book, I realized that I have not explicitly explained the difference between active and passive investing. Here is my attempt:

Apart from different investment classes such as stocks, bonds, gold and real estate we also can divide investments into actively and passively managed. This may be a good point in our discussion to discuss these terms and how their use is somewhat confusing.
First, when you run your own business you are in active investment mode, i.e. you are in control. You decide the direction of your company, you decide about its products or services, its working hours, how much money or equity you put in, whether you take on partners and whether those partners have a say  or no say in your company. You decide whether you want to borrow money and on what terms.
Of course there are constraints because you and your company do not live in vacuum. The bank or creditor who lends you funds will set conditions and limits; so will your clients and then there is the ever present most silent partner of all – in the U.S. we call him Uncle here in Canada it is the government.
Not only do you have equity in the company that is supposed to make profits for you and your partners, there is also your sweat – you work full- or par time in the company, you are often a or the board member and CEO. Thus in active management you put in money and sweat. The sweat returns are defined as your compensation while the rest of your returns are in the form of appreciation and dividends. 
Some active investors make the mistake to count the sweat as part of the return on equity (the money they’ve got invested in the company) and include it in the rate of return. However, to compare performance of active with passive investments you should only use your return on equity.
Your sweat return should be compared with the salaries or sweat returns of passive investors. They often get salaries and other forms of compensation from their own businesses or places of employment. They don’t typically include those returns in their portfolio performance considerations either.
When comparing returns from real estate versus that of stocks, one should make a clear distinction between sweat return and return on equity. For example when investing in rental properties, we’re running our own business while when investing in shares of public company we’re only buying the profits and do not ‘sweat’ unless the temperature in your arm chair is turned up too high.
There is a second form of active and passive investing.  When investing in specific shares, bonds and other paper securities of a company you control the content of your portfolio. This is opposed to investing in an ETF where you just buy the index and sit back and collect the dividends and appreciation. These approaches are also called active and passive investing, but it is now about controlling the composition of your portfolio. The passive investor has given up control even further, delegating the selection of individual investments to an portfolio manager who is paid via commissions and MERs (management expense ratio).  

So basically, active and passive investment is related to the various degrees of investor control.  In this blog we use the terms ‘active and passive’ depending on its context. In real estate  it is of the first form (it deals with controlling a business) .When dealing with stocks and other paper securities, active and passive relate to how the portfolio’s composition is controlled.

No comments:

Post a Comment