Editor’s note: This article contains information only. It is not intended as personal or general advice. Your Money recommends seeking professional advice specific to your personal circumstances.
If you’re looking to invest in a managed fund, you’ll have the choice of putting your money into one that’s actively or passively managed.
So, what are the ins and outs of each investment approach and which is right for you?
What is passive investing?
A passive investment is one that doesn’t require human intervention but instead follows a set of rules or invests in a prescribed set of companies without considering how well they’re likely to perform.
Common examples of passive investments include exchange-traded funds (ETFs) and the kind of “low-cost S&P 500 index fund” that investors like Warren Buffett have famously advised investors to buy into.
When you invest in a passive fund like this, your investment will follow the growth, or decline, of the market represented by the index – known as the benchmark.
An S&P index fund simply follows the benchmark of the share prices of the 500 largest companies by market capitalisation listed in the United States.
Since a passive fund requires no human steering, management fees are minimal. And depending on which index they’re tracking they can be a reliable but unspectacular investment choice.
For instance, although the S&P 500 declined over the past 12 months, its tendency is to rise in the long-term and its value has roughly trebled since the Global Financial Crisis.
The risks of investing passively
Passive investments are far from risk-free, however, warns Alva Devoy, managing director of investment manager Fidelity Australia.
She notes, for example, if you were investing in an S&P 500 index fund, a fall in the share price of a very large company such as Apple or Amazon could send your investment plummeting.
“Without an active manager to watch out for overvalued companies, a sudden market correction can really impact your index fund,” she says. “This happened on July 26 this year when Facebook lost $126 billion of market capitalisation in one day.”
According to Devoy, Fidelity’s managers were able to spot problems with Facebook stock beforehand, and pull out before it impacted their investors.
The alternative: active investing
In an active investment, a fund manager attempts to beat the market by making calls on which companies are likely to perform, and which are likely to under-perform.
That’s no easy task.
During the 2017-2018, 57.6 per cent of general Australian equity funds under-performed the benchmark of the S&P/ASX 200, an index representing Australia’s largest 200 public companies.
And according to a recent report by the S&P Dow Jones Indices, more than 70 per cent of Australian general equity funds and AREITs [Australian real estate investment trusts] under-performed their respective benchmarks in the decade to December 2017.
When a fund manager does beat the market, it usually comes at a cost.
The fund manager is likely to reward themselves with a cut of any profits in the form of a performance fee.
You’re also likely to face an entry fee, contribution fees for any additional money you put into your investment and a fee for the ongoing management of the fund.
This management expense ratio usually equates to something between 0.5 per cent to 2.5 per cent of your portfolio each year.
These fees can add up quickly, making active funds often significantly more expensive than passive ones.
And yet, Devoy argues there still is a place for active investing.
“Say you want to invest in the global emerging market, which is typically more volatile than the S&P 500. The human intervention of a fund manager can help weed out certain companies that are likely to suffer corrections and instead concentrate your holdings in a narrower range of companies,” she says.
You’re also getting the wisdom of professional portfolio managers who spend their working day analysing company performance, interviewing key executives and board members and generally making sure they know all about where your money is going.
Allocating your money
If making a choice between these two approaches, Professor David Feldman of the School of Banking and Finance at UNSW advocates a simple formula – and one which involves both passive and active investing.
“First, ensure you have enough liquid assets, such as cash, for emergencies,” he explains. “You’ll lose on interest income here, but that’s the cost of having liquidity in case of unexpected events.”
Feldman says that of the amount leftover, keep most – say 75-85 per cent – in passive investments such as index ETFs, with the remainder into actively-managed funds.
“The more wealth you have, the more you can allocate to the latter,” he says.
How to choose a fund
Many investors try to solve the uncertainty by simply looking for a manager who is doing well.
Yet, as Aidan Geysen, a senior investment strategist for Vanguard Australia, says, active managers have cycles of out- and under-performance.
What seems like a solid choice now may just be a case of “buying into a manager when they are high.”
“As the classic disclaimer goes, past performance doesn’t indicate future success,” he explains.
According to an S&P Dow Jones study of 183 Australian active funds ranked in their respective top quartiles at the end of 2015, only 14 (7.7 per cent) stayed in the top quartile in the next two consecutive years; and only 1.1 per cent of the high-performing funds in 2013 maintained a top-quartile rank over the subsequent four consecutive years.
The issue of human intervention comes with some very human questions. When choosing a manager, Geysen advises focusing on qualitative questions, rather than trying to quantify their expected gain.
He says you should take the time needed to form a judgment about the people involved in the fund management, and the incentives of the firm’s structure — whether they are aligned with your interests.
Stick to what you can control
One assumption that has statistically helped people, according to Geysen, is to look for a low-cost manager.
Cost is one factor you can control and is a natural advantage for passive funds. According to Geysen, investors who may not have the time or experience to assess a manager’s skill level may be well served to start with a low-cost, diversified index portfolio.
On top of this, Geysen says you need to take into account your personal tolerance for risk – this may take some introspection.
Ask yourself, what’s your personal comfort level? Could you handle a potential short-term fall in the pursuit of long-term gain? Will you follow through when things get uncomfortable, perhaps even if your investment’s value falls below that of your initial capital?
Geysen believes a skilled manager may regain that value, but that won’t matter if you’ve cashed out during this period of under-performance. In some cases, he says, behavioural coaching can help worried investors save themselves from selling too soon.
Passive investing provides a useful entry point for investors, whose gains are protected from high management costs. Historically, it often proves to be a safer choice.
However, in riskier markets or at particular times, human intervention can be very helpful. Your timeframe and patience also matter a great deal when deciding where to allocate your funds.
Ultimately, your decision should depend on your sense of the market, how well you know your manager and also how well you know yourself.