Active & Passive investments: what are they?

01st Nov, 2017 | Investor

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If you follow the investment media, one of the ongoing debates is the value of passive versus active investment. It’s akin to the old Holden vs Ford debate, or the Rolling Stones vs Beatles rivalry.

f you want professionals to invest on your behalf, in anything from shares to property to bonds, you’ll need an investment manager. 

Also known as a fund manager, these firms choose and buy investments on your behalf, and provide you with the returns (or losses), after paying a fee for their services. This fee is usually a percentage of the amount of money you’ve invested with them. 

These fees are at the heart of the debate, because a key difference between active and passive managers is the cost. However, there are other factors too, which we look at in this article.

What is an active manager? 

These managers spend time and effort picking the investments they put into their portfolio. They do research or have processes based on their own investment style, and choose assets that they believe will deliver a good return. 

In fact, active managers want to deliver more than a ‘good’ return – they are seeking ‘outperformance’. This means their portfolio performs better than their peers, as measured by a benchmark or index.

The benchmark they measure themselves against depends on the type of investment. If it’s Australian shares, it may be the S&P ASX200 or the ASX All Ordinaries, or for global shares in might be the MSCI World Index. There are also benchmarks for more specific categories such as small caps, fixed income and futures.

An active manager will usually set a target for their managed fund’s performance, based on their investment style and risk appetite. For example, they may target ‘3% above the S&P ASX200 after fees’. That means if the average return of the top 200 companies was 7%, your manager is seeking to deliver 10% returns (or more). 

There is an emerging type of active management known as ‘goals-based’ or ‘absolute return’ investing. These managers don’t compare themselves to a benchmark, but instead set a goal and work to it, regardless of the broader market’s movements. However, this is not yet a mainstream approach.

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The question of fees

The return target mentioned above includes an important detail – it’s what you get after the manager takes their cut, which could be anywhere from 0.5% up to 2% or more.  And sometimes, in addition to a management fee, there is a performance fee.

For example, if the management fee is 1% but  the fund hits a return target, an additional fee is taken out too. On the one hand, this rewards the manager for their good work; on the other, it eats into your returns when you have a good year. Critics argue that the manager is only doing what they are meant to do: outperform.

But unlike performance fees, the issue with management fees is that you pay regardless of performance. If the fund loses money, you still pay. At the heart of the active vs passive debate is the notion that investors are paying more, but don’t always get good performance.

It all depends on the fund manager and the timing. Some investment styles perform well in certain conditions, but when the cycle turns, their performance falls behind.

And then there is the skill of the managers themselves – it can sometimes seem like picking the best quality managers is as hard as picking the actual investments in your portfolio.

What is a passive manager?

Technically speaking, passive investing is using a buy-and-hold strategy rather than actively trading shares, with the aim of minimising transaction costs. However, it has mostly come to refer to Index Funds, named because they mirror the make-up of an index.

The Investment Manager is not undertaking fundamental analysis or making decisions about the merits of particular investments. As a result, these funds don’t employ as many investment professionals, so they charge lower fees compared to active funds.

Index investing was pioneered by Vanguard in the 1970s, and expanded in the 1990s with the introduction of Exchange-traded funds (ETFs). These funds allow investors to choose very large baskets of stocks representing different parts of the market, and are traded on the stock exchange.

The rise and rise of ETFs

ETFs have exploded in popularity in recent years and this was in part because investors lost faith in active managers, when active funds suffered significant losses during the Global Financial Crisis. The Betashares Australian ETF Review shows that there were $33.5 billion in ETF funds under management at the end of October 2017 – a compound annual growth rate of 31% since 2004. [i]

A big attraction of ETFs and other passive types of investment is the low fees – generally less than 0.5%. They also provide access to a large range of asset types, all through the Australian Securities Exchange.

For example, you can invest in an ETF that provides exposure to the performance of the price of gold bullion, and is backed by physical gold bullion, by buying a Gold Bullion ETF on the ASX. The same goes for commodities, global shares, bonds and more.

Some commentators worry about the liquidity implications of so many ETFs being available on the market, if everyone decides to sell theirs at once.  Because you own units in the ETF vehicle, not the actual underlying shares, this could make it difficult to sell in a downturn.

One trader said, “It’s like having a building with four lines of people coming in through four entrances, but only one exit [that] everyone will have to pile through in the case of an emergency.” [ii]

What to choose?

There are certainly pros and cons to each style of investing. Some investors find that a mix of both types provides diversification, manages costs and delivers returns. A good financial adviser will be able to recommend the right managed funds for your needs.

Our Approach

At Yellow Brick Road, we believe that both active and passive management have their place in client portfolios. We are always conscious of the effect of costs on client portfolios and we believe that diversification is important to reduce exposure to individual investments and to single asset classes.