Investment basics – Active vs Passive investment – what’s it about and, our approach – Episode 58

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Investment basics – Active vs Passive investment – what’s it about and, our approach – Episode 58

When I started my career in investment markets almost 20 years ago all the investment options were what we’d now call Active. We didn’t call them that at the time, it was just the standard way that money was managed.

Passive investment had been around for some time, pushed primarily by John Boggle of Vanguard which first launched a passive index fund in 1975. But it took quite a while for enough data to come in, for investors to begin to appreciate why some hard questions needed to be asked about the focus on Active investment management.

In more recent times the trend has swung in favour of the passive approach, and variations of that process, with ETF’s (Exchange Traded Funds) driving broad adoption.

The increased acceptance and utilisation of passive investment strategies is almost certainly the biggest shift in investment strategy thinking since managed funds kicked off in Australia in 1955.

So in today’s episode I’ll be sharing with you the difference between these two approaches, and how we apply these alternatives when helping our financial planning clients.
mini retirement
As mentioned, Vanguard is the best known proponent of passive, or index investing, though interestingly Blackrock is bigger.

The idea of passive investment is that instead of trying to do research on different companies and identify winners, you simply buy the whole market. The thinking is that if you do this, you should get the average return of all investors. So let’s say you’re buying an index fund over the ASX200 – the index of Australia’s 200 largest companies. If the ASX200 grew by 5% one year, then that tells you that across all of the investors in that market, half did better and half did worse, and the average came in at 5%.

So if you invest in a passive index fund over the ASX200, you will get the average return, 5% in this example, less whatever fees the fund manager charges.
Now compare this to the Active manager. Their entire rationale is to beat the market. If the average is 5%, their entire rationale for existence is that by doing all sorts of research and analysis, they can identify insights others have missed, and so deliver superior performance compared to the rest of the market.
Now the astute Financial Autonomy audience will immediately identify that given the mathematical foundation of an average is that half of all results will be below, and half will be above, then clearly, not all active fund managers can be successful. Now it is fair to say that not all participants in investment markets are fund managers, there are of course mum and dad investors too, but by far the bulk of trade is conducted by the funds.

And so we arrive at the number one challenge when working with active fund managers – what if you choose one that under-performs?

But in actual fact, it gets even harder, because not only does the successful active fund manager need to beat the index, but they need to do it after their fees, or at least the difference in their fees versus a passive index alternative. And active fund managers tend to like to pay themselves a lot. So beating the average by say half a percent, won’t cut it if the fund charges 1% to manage the money in the first place.

So what do the numbers tell us? In data to the end of 2017 (SPIVA Statistics and Reports), when measured over 5 years, only 37% of active funds outperformed the benchmark, and in the US it was even worse with only 16% achieving what they’d set out to do.

To put it another way, if you have some money to invest and you’re trying to pick an active fund manager in Australia, there’s a 63% likelihood that you’ll pick the wrong fund and get under-performance. And in fact that number might be generous due to something called survivorship bias – funds that perform really badly close, and so they don’t register in the data.

Now to be fair, index managers underperform the benchmark too because of their fees. But because they don’t need to employ overpaid fund managers, their fees are really low. You can buy an index fund over the Australian share market for a cost of about 0.14%, and over the US market for an incredibly low 0.04%!
I thought this quote from Brian Portnoy author of The Geometry of Wealth summed things up well: “Beating the market. That’s a silly and fruitless game. It’s not tied to your real needs. It’s attached to your ego.”

Tying your investment decisions back to your needs, or goals is really important. You’ve got a goal, let’s say that’s to buy 5 acres out of town and grow your own food. To make that a reality you determine a dollar amount that you need to save up to enable the purchase. Now of course you could just chip away putting your savings in a bank account until it builds to the necessary amount, but it’s likely to be smarter to invest your savings and let compounding of returns do some of the work for you.

A lot of what we do for clients is financial modelling to ascertain how their goals can be met. So for instance we might find that, given your existing financial position and capacity to save, you could achieve your goal in 6 years, assuming your investment earn an average of 7%.

If you then embark on that journey, you want to have a high level of confidence that your investments will indeed earn 7%. A portfolio would be constructed to gain you adequate diversification and minimise risk. Now you could choose as part of the portfolio to employ active managers, in the hope they will do better than the market, and so, deliver to you higher returns than you’d assumed so that you reach your goal sooner. It’s certainly tempting.

But let’s revisit the data. 63% of Australian active funds and 84% of US active funds fail to beat the benchmark after fees. So is that a bet worth taking?

My preference would be to do whatever we possibly can ensure your goal is met, and that means having the highest confidence possible as to what the investment outcome will be. All investments involve risk, and returns are never guaranteed. But I know that if I invest in a passive index fund, I’ll get pretty close to the market return. And I know what on average that return will be, so that over a 6 year time frame, as is the case in this example, I can embark on the strategy with a high degree of confidence that in 6 years’ time I’ll have the funds needed to buy my little farmlet.

Now I should just pause here a moment and flag that I’m not totally of the view that all active management is a waste of money. We have many clients who’ve chosen to incorporate ethical considerations into their portfolio, and specialist fund managers, particularly with a focus on sustainability have delivered some great results that have indeed exceeded benchmarks on a consistent basis.

There has also been some evidence to indicate that in the Australian small company space, active management might add value. Here many of the participants are day traders and simple punters, and so there does seem to be profits available to investors by employing fund managers to go out and research less well known business, and then sifting the wheat from the chaff.

As the weight of money has moved from active management to passive over the years, active managers have responded, producing strategies to improve portfolio diversification and complement other passive holdings.

 

There’s another interesting wrinkle in this discussion of passive vs active investing, and that is investor behaviour.

There’s great data out of the US produced by Dalbar which compares the market return, which is what a passive index investment will deliver, to the return that the average investor actually experienced.

Over 20 years to the end of 2016 (the most recent data I could find). The S&P500 index returned 7.7%. However the average fund investor achieved returns of 4.8%, a difference of almost 3%. Over 20 years that is huge! To put some dollars around that, $100,000 invested at 7.7% grows to $440,000 in 20 years, whereas if you earn the lower 4.8%, your $100,000 gets to a much lower $255,000.

So what’s going on? The main answer is that investors jump in and out at the wrong time. They tend to get in after markets have had a few good years, and then they tend to get out when markets drop. To get the average market return therefore they needed to do 2 important things:

  1. Invest so that your money tracks the index, which is most easily done with an index fund
  2. Leave your investment alone – all the evidence suggests that investors who try and time the market fail, and as shown in the numbers just mentioned, the impact is not minor.

So armed with this knowledge, how do we tackle things at Guidance, my financial planning practice? We don’t have a one size fits all approach, however our starting point is to use index solutions such as ETF’s, and then add in active management only where there is a specific strategy requirement.

A solution that we use a lot is model portfolios built using entirely index funds, but with an overlay as to the allocation across the sectors, eg. Australian vs International shares vs Property. Once a year the model manager, a large US based global institution, conducts a detailed review of market and economic conditions, and rebalances the asset allocations within certain band limits to reflect what they see. They’ll never be all in Australian shares, or hold none at all, but depending on their assessment, they might tilt allocations 3 or 4% in one way or the other. They’ve been running models this way for over 30 years and their performance has been enough to cover fees and deliver a slight out-performance against the market benchmarks. Given our job is to help our clients achieve their goals, this is the outcome we want delivered. The more certain the outcome, the better.

 

In my book Financial Autonomy – the money book that gives you choice, we step through the framework below. The content covered in this blog and podcast explore each of these steps. Learn moredown a free sample of the first chapter here.

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