Broadly speaking, investment funds can be split into two categories – active and passive. But which one is better, or more importantly better for you?
Historically, active investment has been the primary selection for investors, although the tides are continuing to shift further towards passive investment. Passive investments, specifically the Australian exchange-traded fund (ETF) industry had a landmark year in 2020, attracting $20 billion in new money, growing the industry to just shy of $80 billion by December 2020, according to Morningstar. This equates to almost 30% of the Australian equity market. With growing inflows towards the passive sector and away from active fund managers, which is better and why?
Active investment is a style of investment that involves a fund manager choosing the assets within the fund. You are essentially backing the manager to use their skills to outperform the market. Especially, applying their skills of analysis they can avoid the overpriced companies and buy those that have better prospects, and in the long run beat those indexes. As you are utilising the manager's expertise, this comes with a base fee and performance fee.
Passive management is a style of investment that aims to replicate the returns of a particular market or index (for example, the S&P ASX 200 index). This means, that when the value of the index rises, so too does the value of the fund, and vice versa when the index decrease. A key drawcard for passive investment is the low-cost nature as you not paying a manager for their expertise.
One of my main concerns with many passive index investments is that the strategy is based on market capitalisation (size) and price movement, not by changes in the value and quality of the underlying business.
For example, if you buy an index fund that replicates the Australian S&P/ASX 200 index you are effectively buying a piece of the top 200 companies on the Australian share market. The higher the share price rises of a company within this index, the more of that company you are “forced” to buy. Conversely, if a stock falls in value the index fund would reduce this position to maintain its level within the index’ weighting. Or sell it all together if it drops out of the index.
Last year, the biggest five companies in the S&P 500 have been the ones that have driven most of the recent returns. As of May 2020, the five largest stocks had returned 35% year to date, and the other 495 stocks had declined by 5%.
Ideally, you want to be reducing or selling the over performers and buying a quality business that is undervalued. Sticking to the age-old strategy of buy low, sell high.
Now, just because we can see a potential problem with passive investment, it does not mean it does not have its place. If low cost and long-term investment strategy is your objective, there is no reason why this approach would not work. In contrast, if you choose a qualified and proven financial adviser, active investment is always worth considering, it is paramount for investors to understand the mechanics of how each style works and the difference between the two.
At Hewison Private Wealth we believe client outcomes should be the main priority. Investment decisions should be driven by client needs and tailored to individual circumstances and financial outcomes.
There is no point in investing in the cheapest fund if it is not meeting your goals and objectives. We favour a direct investment approach and design a tailored asset allocation to assist our clients to meet their goals and objectives. Our client's portfolios are adjusted or rebalanced as needed to remain in line with their specific asset allocation or to take advantage of market opportunities.
A direct investment approach provides our clients with ultimate control over their investments. For example, owning an investment directly means you know exactly what level of income it pays. It that level of income changes, the decision is yours whether you remain invested or exit.
Hewison Private Wealth is a Melbourne based independent financial planning firm. Our financial advisers are highly qualified wealth managers and specialise in self managed super funds (SMSF), financial planning, retirement planning advice and investment portfolio management. If you would like to speak to a financial adviser on how you can secure your financial future please contact us 03 8548 4800, email firstname.lastname@example.org or visit www.hewison.com.au
Please note: The advice provided above is general information only and individuals should seek specialised advice from a qualified financial advisor. The views in this blog are those of the individual and may not represent the general opinion of the firm. Please contact Hewison Private Wealth for more information.