Investment funds can be broadly divided into two categories: active and passive. While both options play a part in an investment portfolio, it’s important to understand how each works before allocating money to it.
Basics of passive investing
Over the last decade, passive investing has gained momentum in Australia and beyond. This investing style aims to replicate the returns of a particular market index (for example, the S&P ASX 200 Index).
This means that the fund’s value will rise when the index’s value rises. On the flip side, as the index’s value falls, so does the fund’s value. The result is that your investment performs about ‘average,’ which is the same as the market.
Exchange-traded funds (ETFs) are some of the most popular passive investments. They are similar to managed funds in that they involve a trust structure that holds a basket of securities. As described above, the investments in the fund replicate the makeup of the relevant market index. For example, if the index is made up of stocks that include banks, mining businesses, retail companies, and supermarkets, the ETFs will also hold these stocks.
ETF units are listed on stock markets and can be traded like shares.
It’s important to note that while there are also actively managed ETFs, passive ETFs are the most common.
Basics of active investing
In contrast, an active approach to investing involves a fund manager choosing the assets in the fund, depending on the manager’s view of markets and the type of fund.
Like passive investments, many actively managed funds offer exposure to different asset classes and industries. Rather than track an index, an active fund will target a return above a particular benchmark. An example is that every year, an actively managed fund might aim to achieve the same return as the S&P ASX 200 plus two per cent. Another common way of measuring the performance of an active fund is for it to target a premium above the inflation rate. For example, a fund might aim to achieve inflation plus two per cent per year.
Cost-benefit analysis: fees
Cost is one of the major differences between these two fund styles. Typically, passive investments have lower costs, as investors do not pay for the fund manager’s expertise in choosing the investments in the fund.
Conversely, active funds typically charge base and performance fees to incentivize the fund manager to produce the highest possible return.
Market conditions
It’s important to remember that markets will always go up and down, and actively managed funds still have many benefits (as well as risks) while factoring:
- Funds that track an index only produce the return of the index.
- Fund manager skills can be used to pick investments that have the potential to do well when economic growth is slow, and markets are falling.
- Active managers can also avoid stocks and sectors that are not doing well.
It’s challenging to understand whether actively managed funds perform better over time than passive funds. It’s probably more instructive to consider how each style of investing is used in a portfolio.
Styles applied
A core and satellite approach is a common strategy involving active and passive investing. In this approach, the core of the fund tends to consist of passive investments that follow the market, while the satellite part of the strategy consists of more specialised investments.
There are several ways to apply this style, but a popular technique is to use low-cost index or passive funds as the core, such as ETFs that track one or more major market indices.
The satellites comprise actively managed funds that allow an investor to express specific views by selecting their asset exposure. For instance, an investor may allocate funds to an actively managed technology investment fund, believing that this sector will perform well. An investor may decide to apportion funds to an actively managed gold fund, thinking that this commodity may provide a hedge against market volatility.
There are almost endless ways of using actively managed funds to express views about how different asset classes and sectors will perform over time.
A balanced perspective
There’s really no right or wrong approach to investing in active and passive assets. Many investors combine the two styles to diversify their portfolios and access a broad range of asset classes across the risk spectrum.
We recommend speaking with the team at Everalls Wealth Management to help you navigate the options that best suit your financial goals.
Source: BT
