Active vs Passive funds

Slowing property prices, impending interest rate rises and threatened changes to negative gearing have some millennials wondering whether property is still a viable investment.  In fact, you might be wondering this regardless of which generation you are from. Property investment is a big decision and the debt you’ll be facing will lock away a sizeable portion of your funds in the foreseeable future. So, as a millennial, if we can’t have our smashed avo and a house to go with it, what are the alternative options available to us with long investment horizons and a bit of change in our pockets?

One alternative is stock market investing. In contrast to property, stock investments can be a bit of a rollercoaster ride because of stock market volatility. Additionally for those who are new or inexperienced to the stock market, it can be difficult to pick stocks not to mention the time and dedication required for picking those stocks. 

That said, there are two ways you can go about investing in the stock market without having to pick stocks yourself:

1) Invest via a passive fund (e.g. Exchange Traded Fund (ETF)) providing market exposure (“beta”) or;

2) Invest in an active fund, which is a chance to capture additional returns above the benchmark index (“alpha”)

Let's start with passive investing.  Passive funds (accessible via ETFs)  generally not to attempt to outperform an index (e.g. the ASX 300, MSCI World, S&P 500 etc), but instead replicate the performance of an index (hence capturing the market beta). The key advantage is that they are accessible at a low cost.  And in recent years, the beta has been solid (thanks to a low return environment), which means you could have earned a fairly decent return just by being invested passively in the index (as shown below).

Cumulative Performance of Australian and Global Equities

So how do passive funds achieve this? They do this by holding the same stocks in the same weights as the index.  The following is a list of the top 10 stocks currently in the ASX300, together these make up close to 50% of the index.

Top 10 stocks in the ASX 200 Index (as at 14 September 2017)

                                                           Source: Blackrock iShares ASX200 ETF

You will notice that in Australia, there is a heavy concentration to the big four banks. So, if for example, you had a view that banks were going south, then you might want to consider other ETFs (that don't track the ASX300). 

Global indices are much less concentrated, in fact the top 10 stocks only make up around 9% of the index. 

Top 10 stocks in the MSCI All Country World Index (as at 14 September 2017)

                                                           Source: Blackrock iShares MSCI ACWI ETF

Instead, you will notice that the global index (as represented by the MSCI All Country World Index) is dominated by stocks in the US. Be aware, if you invest in a global ETF, there is also currency effects to think about.  

But there is a lot more sector diversification in global indexes, as you can see in the chart below:

Australian vs Global Index Sector Breakdown

There are also very sector specific ETFs (e.g. Technology ETFs, HealthCare ETFs) and ETFs targeting certain regions.  There are also ETFs on ETFs! And ladies, did you know, there's even a "SHE" index (offered by SSGA), which is made up of companies that have a minimum representation of female members on the Board. Anyway, I digress.

Active funds on the other hand will aim to outperform the index, and are therefore more costly (generally for retail investors over 1%).  Managers that beat the benchmark are said to have generated "alpha", and investors are willing to pay a higher fee where a promised alpha is actually delivered.  The problem is, many managers that claim to be passive are actually "benchmark huggers", that is, their stock positions are closing "hugging" the benchmark.

Having read all of this, naturally you will ask: which is better? Unfortunately there is no straightforward answer. In the last few years, there have been massive outflows from active equity funds to passive equity funds and raging debates about whether "active management is dead".  The reasons this has come about are:

1) Cost - Active management can be very expensive, often the alpha generated by active managers is eroded by the huge fees that they charge

2) Performance - the last few years, equity markets have performed pretty strong overall (see the cumulative return chart above).  So why pay an extra fee if you can get decent returns from a passive fund?

3) "There is no alpha" or "Alpha is not consistent".  This is the most contentious point, and heavily debated in the industry.  Whilst many funds will promise great returns (and charge you a heap for it), many in fact will fail to beat the benchmark.  But is that really the case?

The table below from Morningstar shows that in Australian equities, over a five year period, close to 70% of active Australian broad cap equity managers fail to beat the benchmark, and close to 40% of Australian small cap equity managers fail to beat the benchmark.  

Yes, the alpha in small caps is generally stronger than the alpha in broad caps, this is partially to do with the poor benchmark in small caps land (details in another blog).

The truth is, no active manager will be able to beat the benchmark ALL the time, there will be periods of time where active managers underperform, and you have to have the nerve, or patience to hold through and see your investments through.  The trick is to be able to identify managers that will eventually turn around their performance in their rough patch.

So to summarise, here are some of the key features of active vs passive investing:

Summary: Active vs Passive Investing

So what's the final verdict on active vs passive? To say active funds are better than passive funds or vice versa is overly simplistic, as your investment aspirations are unique and will depend on 1) your investment horizon, 2) your appetite for risk and 3) your skill in picking a fund that will outperform for you.