The debate between passive and active investing is often presented in black-and-white terms. Investors can choose to use passive funds that track an index or favour active funds that aim to outperform an index.

Both investment styles – or a combination of the two – can help investors achieve their goals. The key is understanding the pros and cons of each and making an informed decision.

The trouble is that many investors base their decisions mostly on fees.

While fees are important, they only tell part of the story. Some passive funds have higher risks than many investors realise. Active fund managers use portfolio manager expertise to take calculated risks. If successful, they can earn their fees many times over.

Start with risk. The Australian share market (by market weighting) is dominated by large banks and mining companies. US share markets are dominated by a small group of giant tech stocks. As a result, investing in passive funds that track these indices means greater exposure to a narrow group of sectors or stocks. That’s the risk of index concentration. Active managers are not anchored to the dominant weights in the index and may be well-positioned to navigate an evolving market landscape.

Next, consider what constitutes the index or ‘what’s under the hood’. The Australian share market has some great companies and some low-quality, overvalued ones. With an index fund, you get ‘the good, the bad, and the ugly’. An actively managed portfolio can offer investors access to a concentrated portfolio with deeply researched and hand-picked high-quality companies.

Index momentum is another consideration. We mentioned earlier that index funds hold stocks based on their index weighting. When company A rises in value (and has a higher index weighting), the index fund must own more of it. When company B falls in value (and has a lower index weighting), conversely, less of this share is held. When the Indices that reflect the world markets are rising and are doing so because of momentum and index funds are buying more and more of what we would term as ‘overpriced securities’, we question whether this is the best allocation for investors hard earned cash.

We expect our Investment Managers to buy high-quality companies when they are undervalued and sell when they are overvalued. Often, that means buying stocks after they have fallen and selling after they have risen, contrary to what the rest of the marketplace is doing. We also expect that if they purchase a stock or security and it’s a good investment, then they should hold that stock for the long term or at least until such time as the fundamentals change sufficiently to suggest otherwise. No one ever got ahead by trading too much and paying tax unnecessarily is a sure pathway to ‘wealth erosion’.

Finally, consider market volatility. Capitalising on volatility creates opportunity and is one key to earning attractive long-term returns. Expect a lot more of this in the year ahead.

Index funds aren’t designed to capitalise on volatility or, for that matter, the mispricing of individual shares.

When markets fall, index-fund investors receive the index return – which in some years is negative. They don’t have the sophistication of experienced portfolio managers trying to capitalise on volatility.

Then there are returns. Successful active managers outperform their benchmark index over short and long periods after fees. Their funds cost more than passive funds, but the successful active manager aims to provide returns in excess of an index – after fees and since inception.

If this article has sparked any thoughts you’d like to delve into further, please feel free to reach out to us.