Active v passive: Pam Walkley Funds beating the index

Investors are pouring money into index funds but there’s still a role in a portfolio for a traditional active manager

Globally, investors put more money into exchange traded funds (ETFs) than actively managed funds in 2016 for the 10th straight year, according to roboadviser Stockspot. In Australia, funds under management grew by $4.4 billion to hit $25.8 billion by the end of 2016. Worldwide they reached a record high of $US3.546 trillion ($4.7 trillion), according to ETFGI, an independent research and consultancy firm.

The rise and rise of ETFs, most of which track indices and are classified as passive investments, has been at least partly at the expense of traditional actively managed funds, where the manager attempts to beat an index. “ETFs are taking over markets,” said the prestigious

Financial Times newspaper in a December 2016 article. “Shares in Apple, the most traded company, turn over more than $3bn each day. But that is dwarfed by the biggest ETF, State Street's SPDR S&P 500, which trades more than $14bn each day. Five of the world's seven most heavily traded equity securities are ETFs.”

Many individual investors (68%) have a false sense of confidence in passive investing, according to a global study of financial advisers, outlined in an article by Glenn Freeman, senior editor of Morningstar in an October 2016 article on Morningstar's website.

The study surveyed 2550 advisers in 15 countries (excluding Australia) in July and August 2016 and was conducted by CoreData Research on behalf of Natixis Global Asset Managers.

Its findings back up another report from the same sources, released in May 2016, which surveyed 7100 individual investors from 22 countries, including 250 in Australia, where 67% said they saw passive funds as less risky, says the article.

“From our perspective ... it's all about building the portfolio and not about products ... [passive funds] have a role to play, but I don't think you would say that they minimise losses and that they are less risky,” says Kevin Haran, Australian managing director for Natixis.

Some investors think they don't need to research ETFs as they would a managed fund. But Tim Murphy, director of manager research at Morningstar, says this isn't the case. “You must understand what the ETF invests in – it's not too hard with one that tracks the ASX 200, for example, but many are more complex and some investors don't understand that.”

He says most investors would benefit from having both passive and active investments. And some people involved in the ETF industry agree.

Jon Howie, iShares Australia director, says that after fees and tax, most active funds struggle to outperform, and adding ETFs to a portfolio can lower overall costs. But it's important to factor in both, because investors who follow an index are giving up the opportunity to outperform over time. “It's not active versus passive. It's active with passive,” he says.

The term “passive investing” is a misnomer, says Robin Bowerman, head of market strategy and communications at Vanguard Australia, a pioneer in index investing. “If you decide to invest using an index approach, that is, in a sense, an ‘active' decision. The real trick for investors is how do you get the blend right. How do you balance the index offerings and the active offerings. Absolutely, there is a role for active management – that's not something we'd ever dispute,” he says.

Murphy says that his observation, based on anecdotal evidence, is that “active versus passive is not the right debate. It should be low cost versus high cost.”

There has been an increased focus on costs along with greater disclosure. For advisers there are three main costs: advice, platform administration and investment management. Advisers don't want to reduce their fees and it's difficult to reduce platform fees, so investment management is the easiest to target. That means a big driver into passive investments is cost, says Murphy. Some investors have a fee budget, so they hold their core investments in lower-cost options and use the rest of their budget for higher-cost choices, he says.

Another active/passive strategy advocated by fund manager Bennelong is to confine active investment in Australian stocks outside the top 20, because of the concentration in these stocks, accounting for 58% of the S&P/ASX 300 Index.

“Where there are genuine prospects for outperformance, there is a good argument to be made for paying fees. In our view, this arises outside the top 20 stocks, in the lesser-known parts of the market,” says Julian Beaumont, investment director of Bennelong Australia Equity Partners. Its Bennelong ex-20 Australian Equities Fund, which adopts this strategy, has beaten its index (S&P/ASX 300 Accumulation, excluding S&P/ASX 20 Leaders) by an average 5.53% a year since inception in November 2009 to December 2016.

Another attraction of ETFs is that they can be traded on the ASX, says Murphy. Some fund managers have fought back, offering versions of their products as mFunds, meaning investors can access these through brokers.

The downside of investing through the ASX is you have to know how to execute your transactions efficiently. “You need to be a bit smarter about buying because of pricing – for example, use limit orders rather than market orders,” says Murphy.

Another downside is that some investors treat all ETFs as being the same. “There has been a move to strategic beta funds, which aren’t chasing a specific index but are tilted in some way – perhaps they have a dividend bias, a value bias or a growth bias.”

Sometimes called smart beta ETFs, these are now the fastest-growing area among new funds, partly because there is a perception that the more volatile conditions may favour active managers.

It’s been eight years since the last downturn and we’re likely to be closer to the next pullback than not, says Murphy, so it’s a good time for investors to err on the side of conservatism. “Potentially active managers have a higher probability to outperform but that doesn’t mean all will,” he says.

Indeed, the inability of many active managers to better their benchmarks is one of the main reasons investors have flocked to ETFs. Only 22.5% (78) of the 346 funds classified as large Australian equity blend funds by Morningstar beat the S&P/ASX 300 Accumulation Index in the three years to December 2016. In the longer term, the outcomes are better: 29.3% of funds beat the index over five years and 29.6% outperformed over 10 years.

When you’re looking at a fund’s track record, Murphy says that multiple market environments are more important than time. “You could argue that for the past eight years we have been in the same market environment – recovery and growth after GFC. So you need longer – how did the fund perform before the GFC and during it? If you were asking the same question in 2010, three years would probably do.”

If you want to research managed funds, Morningstar (morningstar.com.au) is the only third-party source on funds that makes its information available to individual investors. You get some at no cost but if you want indepth research you need to pay.