Lesson type: Understanding investment philosophy

Active or passive: which fund management style is right for you?

Actively and passively managed funds both have their merits, and deciding which style is right for you will depend on an individual investor. Understanding the differences between these two styles however may help an investor make a more informed decision.

Passive (or Index) advocates will point to studies highlighting that, on average, active managers will underperform (a market benchmark) over time, and that fees charged by passive funds are significantly lower.

Active counterparts, in turn, will argue that they aim to exploit market inefficiencies (such as naïve index trackers who are forced to rebalance based on changes to index constituents, for example) and declare that it all depends on manager quality. That is, a good active manager will outperform, and the challenge is to find the good managers.

Across all asset classes, Lonsec rates an extensive suite of active and passive strategies, applying a tailored rating methodology to both strategy types. When deciding between the two, investors should consider a range of factors:

Performance

Positive surprise: Only active strategies genuinely offer the opportunity for outperformance. An index strategy that surprises on the upside when it comes to performance should be queried.

Negative surprise: Indexing strategies have less chance of giving investors negative surprises and sleepless nights, given they only seek to track an index. For instance, if there is a market correction, it would be expected that an index strategy would fall as much as its benchmark index and not substantially overshoot. Additionally, you wouldn’t expect an index strategy to consciously shift its investment style.

Investment Risk

Whether one strategy type is more or less risky than the other is subjective. For instance, active products can be highly concentrated with significant deviations from benchmark weights; index products can hold companies experiencing poor governance or even fraud, given that fundamental analysis is not conducted. Generally, however, you should expect to be subjected to similar risks as the relevant benchmark when invested in index strategies. For active strategies, this will largely depend on the investment philosophy.

Fees

Unquestionably, indexed products are cheaper than comparable actively managed ones. However, while price is important, it shouldn’t be the only factor to consider.

People

Index strategies have less reliance on their people, given their rules?driven investment process, where stock selection is effectively outsourced to benchmark index providers. Active strategies have a profound reliance on the quality of their people.

Investment Process

Both streams of rated product are expected to have established investment processes.

Corporate

This is situation dependent, however managers that focus on index strategies require a significantly higher AuM level and scale to be competitive, given the lower revenue structure of the products. For example, all index managers of global equities products rated by Lonsec are readily acknowledged as well?established market leaders in this space.

Ultimately, the decision to invest in active or passive investments will be determined by a number of factors including: an investor’s objectives and return expectations, definition of risk and sensitivity to cost, among other things.

A final word on cost – ultimately this should be considered from a ‘value for money’ perspective. In other words, what after?fee outcome is an investor likely to receive by investing in an active approach or a passive approach?

The opinions expressed in this content are those of the author shown, and do not necessarily represent those of No More Practice or its related entities. To view our full terms and conditions, click here.

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