Active Investing VS. Passive Investing

By Greg Major, Financial Advisor

I heard a very good presentation last week from Andy Sowerby of Legg Mason about the benefits of going “active”.

There has been more written about the pros and cons of active versus passive investing than perhaps just about any other topic in the field and the debate will rage. Andy mentioned two simple facts that caught that my ear.

First: active fixed income managers outperform the index on average, but that active equity managers do not – a bold admission from a fund manager. However, he went on to show and explain why it’s no surprise that the median manager can outperform in fixed income. More interestingly he went on to explain why it’s also no surprise that the median manager in equities gets beaten but for those that undertake the right investment process, the benefits of active management are in fact quite grand.

Let’s tackle each of these points in turn (and thanks to Legg Mason for the information used herein).

The index is a debt weighted creature with low yields

Firstly for fixed income, the index is a debt weighted creature largely comprised of US, Eurozone and Japanese sovereign bonds with yields as low as or lower than 1%. Adding value for active managers often means looking at lesser-researched securities in the non-investment grade space and pursuing opportunities where value has not been fully priced, higher yields are on offer and where less liquid trading conditions favour an active approach. Replication of an index of around 18,000 securities across 70 countries is problematic for providers of passive index products, such as the case for the Barclays Global Aggregate Index, which increases the cost and lowers performance for passive managers.

Equity managers that tend to hug the index will eventually get beaten by fees

Those managers with what is termed a low “active share” are characterised as active managers, but display an investment process which lacks conviction and ultimately deviates little from a passive approach, making it difficult for them to consistently outperform their fee load.  At or around the median, it is not unusual to see this type of manager, the corollary being that it is almost statistically impossible for a low active share manager to consistently perform in the top quartile.

The high conviction manager with a good process can outperform the index

What may come as a surprise though, is how much benefit that can bring. Legg Mason showed the benefit which “alpha” (the return over and above the index return) generated by the first quartile manager over a sustained period would bring. This benefit is much more significant for equities than it is for fixed income.  As an example:

  • In World Equities ex-Australia, $100 invested as at 1 January 1993 would have grown to $542 in the passive index but $3,360 in the 25% manager.

The upshot here is that the dispersion of performance between median and those above median is exceptionally meaningful.

Do your research

Overall, I am still an advocate of active management, but the application depends somewhat on the asset class, market conditions and, most of all, your ability to either do your research or find someone who can. Poor research may lead to a poorly performing manager and no better or even worse results than a passive investment.

If you have any questions or would like to discuss your investment strategy, please feel free to contact us.

Greg Major is an authorised representative and credit representative of AMP Financial Planning. Blueprint Planning Pty Ltd (ABN 78 097 264 554), trading as Blueprint Wealth, is an authorised representative and credit representative of AMP Financial Planning, Australian Financial Services Licensee and Australian Credit Licensee (AFSL / ACL 232 706).