Active vs passive funds and your portfolio

We’re not igniting the debate, since both types have their merits

THE PROCESS of structuring your investment portfolio is an exciting step towards taking control of your financial future.  With a wide range of savings products available to you, educating yourself becomes important as you create a portfolio that will deliver healthy, competitive investment returns.

Two terms that you will come across in your investment journey are ‘active’ and ‘passive’ investment funds.  Understanding the distinction between these two types of funds can make a critical difference in the outcomes of your investments.

Depending on your risk profile, investment sophistication, and investing time horison, it will be important for you to judge the merits of active and passive funds, and make an informed decision regarding how you wish to structure your portfolio.

Active funds

Active funds require frequent and on-going active management by portfolio managers.

This active management typically involves teams of research analysts and portfolio managers, who offer a hands-on service that includes monitoring and evaluating the funds you are invested in, and making important investment decisions on your behalf.

The reason why many opt for active fund management when it comes to their investments, is because the objective of active funds is to ‘create alpha’; creating alpha means to always seek higher returns than the market average.

In order to accomplish alpha, portfolio managers select the best investment teams who can stock-pick, evaluate, and act on mispricing in the market.  These teams identify misvalued securities (shares) and execute timely buying and selling decisions, giving the investor the advantage of a hands-on investment service that should, in an ideal world, beat the overall performance of the market.

Given the human capital required, active funds often come with hefty investment fees, which if you do not understand the nature of compounding over time, can erode the total capital you will ultimately receive.

Passive funds

Passive funds, as the name suggests, do not require any active management at all.  They track a specified benchmark over time.

For example, you can invest in a passive fund that tracks the FTSE/JSE Top 40 Index.  This Index reflects the performance of the top 40 largest companies on the Johannesburg Stock Exchange by market capitalisation.

Passive multi-asset funds target strategic asset allocation.  The argument for passive funds is that diversification and index tracking have proven to deliver higher returns over the long term with lower costs than those of active funds.

There are a number of local passive investment options that also track global indices.  This helps prevent overexposure to an exclusively South African selection of passive indices, thus promoting a high level of global diversification within your portfolio.

Where active funds argue that share prices are often misvalued (and therein lies the opportunity for excess return), passive funds work on the assumption that the share price is already trading at fair value.

In terms of this theory, generating alpha by utilising the skill of portfolio managers or investment strategies becomes an impossible pursuit of returns, so rather passively holding shares over the long term becomes the strategy.

By investing in passive funds, your portfolio typically gets an appropriate level of diversification, with low turnover, which is excellent for keeping down transaction costs.  This, combined with low fees, makes passive funds appealing for investors wishing to incorporate them into their portfolio.

Conclusion

Both active and passive funds can find a place in a well-diversified portfolio, but there are a few points to consider.

Your overall strategy becomes important within a passive fund, as these funds adopt a buy-and-hold strategy.  You will have to decide when and how to reposition your exposure, whereas with active investing it’s done for you by the portfolio manager.

While it is true that most active fund managers have failed to outperform their passive counterparts consistently, there are success stories to be found.  Conducting a careful and detailed analysis, and selecting active managers based on merit, becomes critical.

When approached with the right strategy, active management has the potential to deliver above-market returns.  However, scrutinising fees becomes important as you select an active manager.

It is therefore wise to consider your investment objective before making a decision.

Atleha-edu is a non-profit organisation providing financial education to retirement fund trustees and members, in partnership with Strate and the ASISA Foundation.