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Is an active or passive investment approach best for your portfolio?

Glenn Freeman  |  12 Oct 2016Text size  Decrease  Increase  |  

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Whether you're opting for an active or passive approach to investing in large-cap equity funds, make sure you are doing it for the right reasons, and that your fund manager is delivering the service you're paying for.


The majority of individual investors (68 per cent) have a false sense of confidence in passive investing, according to a global study of financial advisers.

The study surveyed 2,550 advisers in 15 countries (ex-Australia) in July and August 2016, and was conducted by CoreData Research on behalf of Natixis Global Asset Managers.

"You've got 66 per cent of advisers saying they use passive strategies as an efficient way to lower cost, because of increased fee pressure. And 57 per cent of them say they also use it as a way to gain access to efficient markets," says Kevin Haran, Australian managing director, Natixis Global Asset Management.

The survey's findings are particularly interesting when viewed in the context of another report it released in May this year, which surveyed 7,100 individual investors from 22 countries, including 250 in Australia.

Haran draws parallels between figures unearthed in the two studies.

"Seventy seven per cent of individuals are saying they want better ways to manage risk, and that they no longer believe the traditional 60-40 portfolio is enough. 74 per cent of them are saying they want better ways to insulate their portfolio against volatile times," he says.

More than two-thirds of individuals (67 per cent) reported they saw passive funds as less risky.

"From our perspective ... it's all about building the portfolio and not about products ... [passive funds] have a role to play, but I don't think you would say that they minimise losses and that they are less risky," Haran says.

"You parallel it to the global adviser survey, where 68 per cent of advisers say their clients have a false sense of confidence through passive investing ... and also, 71 per cent of advisers say that [clients] don't really understand that they're exposed to things like headline risk through passive funds--like ESG or governance aspects.

"We're not saying it's crazy to be doing passive investing, what we're saying is there seems to be a real disconnect here between the trust individuals are putting in [passive funds] and what they're saying that they want."

Haran views passive fund management as an important part of an overall investment portfolio, in helping drive returns and protecting against risk. "You need to think about more active ways to do that, not just passive ways."

Robin Bowerman, head of market strategy and communications at retail index manager Vanguard Australia, believes there is a place for both active and passive approaches in investment portfolios.

"The real trick for investors is how do you get the blend right. How do you balance the index offerings and the active offerings. Absolutely, there is a role for active management--that's not something we'd ever dispute," he says.

"But what we're not seeing in the Australian market is lower-cost active funds ... one of the things that makes it very difficult for active managers to outperform the index are higher fees."

Bowerman also believes there has been a positive shift among retail investors, away from active funds that are so-called "closet index"--those with a three-year average active share below 60 per cent.

Closet index--how active is active?

"The question about if you're in a passive fund, and do you have to compare that to the active fund--it's not even about that. It's about what the total portfolio is doing, and if the client wants a better way to insulate a portfolio against volatility, they need to think about that from a portfolio perspective," says Haran.

As the Natixis study shows, the fee differential between active and passive funds is a key factor influencing investors' choice of approach and manager. But if you've selected an active investment manager, you also need to be clear on just how active it is.

This was assessed in a Morningstar study of the Australian equities large-cap sector in January 2016.

"No one wants to be paying active fees for inactive management. A good way to assess if your manager really is taking differentiated calls from the index is through active share, which measures the active component of an investment portfolio in relation to an index," says Tom Whitelaw, director of manager research ratings.

Morningstar's Australian equities sector wrap has been tracking "active share" since 2011, and over this timeframe has noted a "distinct decline in the 'activeness' of our universe of large-cap Australia equities managers since the global financial crisis".


Rolling one-year active share


Source: Morningstar calculations


This was attributed to the sharp decline in financial markets from 2007, when the sell-off coincided with a reduction in active share. "That's the survival instinct kicking in; you don't get fired for losing money so long as everyone else is doing just as badly," Whitelaw says.

"So, in aggregate, portfolio managers appeared to prefer to safeguard their relative returns by herding around the benchmark instead of looking after the absolute asset values of their investors' portfolios."

However, over the 24 months to the end of June 2015, this level of "activeness" had risen by almost 10 per cent among the cohort of Australian equities managers covered by Morningstar.

"This has undoubtedly forced active managers to try to differentiate their products more clearly from the passive approaches that have been eating their lunch in recent years--something that our fund flow data is also supportive of," Whitelaw says.


Largest rises in active share for the year to 30 June 2015


Source: Morningstar Direct™


Bottom ranked active share funds at 30 June 2015


Source: Morningstar Direct™


The report also addressed the efficacy of active share as a predictor of outperformance. However, according to Whitelaw, a higher active share score isn't a good predictor of performance--though does correlate highly with volatility.

"In most instances, investors would be better off choosing cheaper passive or exchange-traded funds or choosing a more benchmark-agnostic manager if they believe the index is for the beating."

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Glenn Freeman is Morningstar's senior editor.

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