Is it better to invest in passive or active funds?

Welcome to Finance and Fury. Is it better to invest in passive or active funds?

1. Big question, that can have big consequences for an investment strategy
2. Whether investors should opt for actively managed funds or passively managed funds has long been the subject of a debate – and on each side there are some that have very strong views on which is the correct path to take
   1. This flows on from last week’s episode about three factor investing versus the EMH – if you haven’t listed it might be worthwhile checking out – but in essence – either you can outperform the market or you cannot
3. The aim of this episode is to look at the pros and cons of both sides to this argument – and review the historical performance of an average active manager to the index that they track

To start with – lets quickly define active and passive

1. An active investment can be a managed fund, ETF, LIC – really any investment vehicle where the underlying investments are managed by an individual or team of managers tasked with deciding how to invest the fund’s money
2. A passive investment is as the name suggests is passively managed – it has no management team making any investment decisions, but rather the fund follows a market index – if a security, being a share, bond, commodity, really any asset that can be tracked via an index, it can be bundled into an index fund
3. Like an active manager – passive funds have different investment universes – you can buy an ASX300 index – a Small Cap index, a Property Securities index – the list goes on – and each of these spaces there are active managers who rather than simply purchase all of the securities in the index, look through the list and make an active decision around which companies that want to purchase
4. Looking at active funds more closely –
   1. Active managers employ different methodologies to make their investment decisions – as an example – some are bottom up – meaning they look at specific company-specific fundamentals like financials, supply and demand, and the kinds of goods and services offered by a company – others can be top down – which involves looking at big picture economic factors to make investment decisions – it is more macro focused
   2. The aim of an active investment can normally be broken down into two categories – which will be outlined in their investment mandate
      1. One objective is to outperform their benchmark, being the index they are tracking – this will be outlined in their PDS/investment mandate – where they will state that they aim to outperform by a certain margin over a rolling timeframe – normally 3 to 5 years having a rolling return being above the index –
         1. This means they can underperform the index in the short term – but their aim is longer term outperformance – this stye of active management believes markets are inherently inefficient, and that pricing and value anomalies can be exploited to achieve above-benchmark returns
      2. Other funds can have a specific return objective – some may not have an objective to outperform the index they are benchmarked against – but instead have a different objective – such as lower volatility, or providing an absolute return – or higher levels of income
         1. What I have seen form many active managers is that they can outperform in highly volatile markets – but these events don’t happen every day – so how do they do over the long run? We will come back to this
      3. Pros and cons of an active fund – It is great when a fund does what it sets out to do but there can be major downsides when they do not
         1. One major con can be that many actively managed funds have a tendency to underperform or do worse than the relevant market index
            1. the future performance of a particular fund cannot be accurately predicted – past performance is not indicative of future performance
         2. The other major con is that they charge higher fees than that of a passive investment
            1. Don’t get me wrong, both active and passive funds make a profit, it is just that active funds have a much higher overhead than a passive fund – but passive funds don’t have a team of researchers, analysists and portfolio managers to cover the costs of – active funds range from about 0.5% to 2% in management costs – where as passive funds can be around 0.2% in MER expenses
               1. Passive funds normally have economies of scale to have very low trading costs – where as active funds can have higher buy/sell ratios each time you purchase an investment
            2. In addition – Active funds can charge a performance fee – this is a clip of the returns that they generate above the index that they are tracking – if they outperform the index by 5%, they can charge anywhere from 10% to 20% of this, so you are looking at getting a net return of 4% above the index in this example – just note that if they underperform the index, no performance fees are charged
               1. Passive funds cannot charge this, as there is no outperformance over the index

How does the performance stack up – varies across asset classes, but generally there will be benchmark-relative comparisons – S&P Global prepare a global index tracker for active funds to compare the performances to their indexes – this is called SPIVA – short for S&P Indices versus Active – which tracks the performance of actively managed Australian funds against their respective benchmark indices over different time periods

1. These return metrics are usually provided net of fees, to highlight the actual return generated by end investor
2. In the SPIVA Australia Year-End 2020 report, S&P Dow Jones Indices evaluated the returns of:
   1. over 897 Australian equity funds (large, mid, and small cap, as well as A-REIT), 475 international equity funds, 112 Australian bond funds
   2. All of this data is to 31^st December 2021 – so a little under 6 months old
   3. Also note that is doesn’t measure the scale of underperformance – it could be 10% over or under, or 0.01% – it is just looking at the comparison of which funds are over or underperforming
3. Australian Shares – General Equity – Benchmark index is the ASX200 –
   1. In the 12 months from December – only 42% of active managers underperformed the index – meaning that 58% of funds outperformed the index – but does this hold up in the long term?
   2. Not really – the longer timeframes show that the tables turn and active managers start to underperform the index
      1. For 3 years, 62% underperformed the index, at 10 years and 15 years, this is around 80% of funds underperformed the index – meaning that only 20% outperformed
   3. Generally, this means that for large cap funds – managers have a hard time to outperform the index long term – consistency is hard
   4. Two caveats to this result – around 1,000 funds were used in this analysis, so about 200 of this have managed to outperform the index – it is just that there are a lot of funds out of there
   5. Second is that in Australia – I like to refer to large cap managers as benchmark huggers –
      1. When you think about the Australian share market – and even international share markets for that fact – most of the index is dominated by a handful of companies – if CBA makes up 7% of the index, an active manager might be tempted to invest either 8% or 6% in CBA if they think it is undervalued or overvalued, but they will still hold CBA – This active position of a percent here or there in being over or underweight in certain companies can provide an outperformance over the index – but after you deduct the management fee of say 1%, this can actually result in a loss
      2. Active manager also can hug the benchmark due to not wanting to underperform too badly – say they think that CBA is very overvalued, and all banks are – so they don’t purchase any of the big 4 – if there is a resurgence in their price, this means they would probably underperform, given that these 4 companies make up 20% of the ASXs returns

• On top of this, active managers can have hard caps on their holdings at 5% per security – so they may only be able to hold 5% of their allocation in CBA, even though they think it is worth allocating more to

1. There is also the issue of the EMH – many of these large cap shares are more likely to be trading closer to their fair value due to the amount of information available about them, and the number of people covering this

4. Australian Shares – Mid-Small Cap – ASX Mid-Small Index – how does this stack up?
   1. Similar margin of outperformance over the last 12 months – where 42% of active managers underperformed the index – meaning that 58% of funds outperformed the index – but does this hold up in the long term? A lot better than the large cap managers
      1. For 3 years, 44% underperformed the index, at 10 years 56% underperformed and 15 years, this is around 48% of funds underperformed the index – meaning that 52% of funds in the small cap space outperformed the index in the very long term
      2. This is for a number of reasons when compared to large cap shares
         1. Allocation weighting – can have much higher allocations to shares than their space in the index when compared to large cap shares which have a tendency to hug the benchmark – as an example, a small cap company might only have a 0.1% weight in the index, but an active manager can take say a 5% allocation in this company – this can either work for or against them – as if this company does well, they are likely to add to their outperformance above the index – if it goes poorly, then the opposite is true
         2. In the small cap space, many companies can have limited coverage and be trading at a price that can vary from their fair value – the EMH has a harder time when there is less information that is quickly priced in by market participants
      3. In general – when it comes to large cap – it is hard to outperform as an active manager – but more small cap managers have outperformed the index over the long term – but it is still around 50/50
         1. When looking at these results – it is important to remember that some active managers do not target relative outperformance but instead an absolute (positive) return

What is right for a portfolio allocation – This is my personal view – but a combination of both

1. A combination of both actively managed funds and passive funds in the right splits can help to add diversification, through accessing a wider range of asset classes across the risk spectrum
2. This is not advice – but general information on what I have personally done and how I see investments between active and passive
   1. Passive funds in an investor’s portfolio – utilised as a low-cost solution in more predictable parts of an asset class such as large-caps
      9. Index investing in small cap spaces can underperform the in index with a large cap allocation – looking at the 10 year returns for both – the ASX200 has been 9.9% and the Small-mid cap has been 5.96% for the past 10 years when annualised
      10. This is because the small cap sector has many winners, but many losers as well
   2. Active funds in an investor’s portfolio – This can help to provide downside protection and generating returns over benchmarks – particularly in the small cap space to help generate long term growth 

Summary – The choice comes down to you

1. Passive is the easy option – no need to research which active managers to purchase – if you are looking to invest in large cap companies, the index has a history of outperforming active managers –
   1. This doesn’t many that it outperforms every active manager – remember that over 15 years there were still 200 funds in this group researched that outperformed the index – but it is about selecting the right ones
2. Active funds – particularly in the small cap space can help to outperform the index – but remember that depending on your choice, this can be close to 50/50 that you over or underperform – what I have seen is that the funds that outperform have done so by a large margin – this is where due diligence is required to research the investment – what is its volatility, how has it conducted investments in the past, what is its consistency in returns