There is much ongoing debate about the relative merit of ‘passive’ investing verses ‘active‘ investing. Each investment style has a place in most portfolios. Often, it’s more a question of how much portfolio weighting to be applied to each investment style. Ultimately, this comes down to a traditional risk v reward trade-off. To a rational investor, higher risk is only acceptable when it is accompanied by higher reward. This is a fundamental investment principle that is strictly adhered to by rational investors.
An active investing style refers to actively selecting individual investments that comprise the portfolio. In the case of a share fund, a Fund Manager selects stocks to buy and sell, according to research-based judgements. The Fund Manager typically undertakes extensive financial analysis of each company before it is bought by the Fund. This analysis is often backed up by regular meetings with management and site visits to the company’s premises to gain first-hand knowledge of the company’s future earnings prospects. It is considered by some investors that this mix of quantitative and qualitative analysis provides the Fund Manager with an ‘edge‘ over other investors or the ‘market‘ generally. There is evidence to support this ‘market out-performance’ by some Fund Managers.
Active investing incurs transaction costs, requires 24/7/365 hands-on oversight, and is exposes investors to ‘Key-person‘ risk. On the other hand, this investment style provides flexibility to take defensive positions in times of market volatility through buying put options (a form of insurance) or exiting some positions altogether at elevated prices, by selling stocks and investing in cash for a period. Every Fund Manager’s over-arching objective is to ‘sell high and buy low‘. An active Fund Manager may enhance Fund returns by short-selling when markets are high or when individual stocks are considered to be over-priced, compared to their intrinsic value. Fund Managers can short-sell an individual stock or even short-sell an index.
Passive investing is a strategy based on accepting market returns on invested funds. It replicates the return of a specific market index by replicating the assets that make up that particular market index. For example, an investor may decide to accept the returns of the ASX100 and to achieve this outcome the investor can invest in a Fund that comprises every share within the ASX100. The Fund, known as an Exchange-traded Fund (ETF), owns every share in the ASX100, in exact proportion to the portfolio weighting of each individual company in the ASX100 index. The ETF receives and distributes dividends, including franking credits, to unitholders in the ETF. The ETF is quoted on the stock exchange like any other security, and its price moves in sync with the ASX100 index. The ASX100 ETF would comprise shares like BHP, CBA, RIO, CSL Westpac, NAB, ANZ and Wesfarmers, in proportion to their index weight.
Passive investing, given its nature, is a low-cost solution, as few transaction costs are incurred, research is not required, and administration costs are automated and digitised. Risk is spread across the largest 100 stocks in the ASX and the portfolio is highly transparent because the 100 stocks comprising the portfolio are publicly announced by Standard & Poors’ each quarter.
An ETF has no flexibility or discretion around what stocks comprise the portfolio. Portfolio composition within an ETF is rigid and ‘rules-based‘. If a stock increases (or decreases) in price, its market capitalisation will increase or decrease accordingly, and if the change is significant, it may move into (or drop out of) the index. This is the ‘Achilles heel‘ of ETFs. Generally, if a stock price rises significantly, relative to the market, it can become over-bought, and expensive. This sometimes happens to so-called ‘fashionable‘ or ‘flavour of the month‘ stocks.
The point is that if the price rises sufficiently for it to take the particular stock into the index, then the stock must be acquired by the ETF, in direct proportion to its index weighting. There may be occasions when this stock will rise further in price, purely because of ETF-related buying. In other words, an expensive stock can get more expensive, irrespective of its intrinsic or fundamental value. Fund Managers, on the other hand, buy stocks considered to be under-valued and sell stocks when considered to be over-valued. Fund Managers have been known to advantage their Fund portfolio by selling into ‘index buying‘ by ETFs. Fund Managers recognise the difference between value and price.
The converse applies to a stock that falls in price sufficiently for it to be ineligible to remain in the index. This stock must be sold by the ETF, which is bound to only hold stocks that comprise the particular index. Again, Fund Managers can take advantage of this situation, Fund Managers know that a ‘cheap‘ stock can become even more cheap, because of indiscriminate selling, in which case a Fund Manager may continue buying, and average-down the entry price of a particular stock. This value-oriented investing style is peculiar to Fund Managers and ETFs do not have the discretion to adopt this strategy.
There is no right or wrong investment strategy. Both strategies have merit and both strategies can co-exist in managing risk in a portfolio, whether it be shares or bonds or any asset class covered by an ETF.
Managed Funds which are discretionary in portfolio composition, tend to out-perform the market during times of market volatility or when the economic cycle is turning. Markets are driven by the economy. A Fund Manager can pro-actively buy aggressively when the economy is strengthening and pro-actively sell aggressively when the economy is peaking, following a period of sustained GDP growth. An ETF cannot lead the market in this way and must follow the market by sticking to the index. Index Funds and ETFs perform best when stock valuations are uniform and consistent and economic conditions are stable.
This means that a blended approach of both passive and active strategies can achieve an optimal outcome. The economy is cyclical and market conditions can change. A trained and skilled advisor attuned to the state of the economy and to market conditions, is well placed to recommend an appropriate mix of passive and active investment styles and to balance risk with reward, to achieve superior risk-adjusted returns.