There is huge debate within investment circles as to what is the best long term strategy for superior returns: an active strategy, where an investment manager picks securities which s/he hopes will outperform the market, or a passive strategy which effectively invests in the whole market, and returns are aligned to the market overall.

Passive strategies are generally cheaper (lower fees), as they are programmatically driven – a passive fund will own exactly the same securities (and in the same proportions) as the overall market that it tracks.  There are no investment decisions required, other than to buy or sell to match the market over time.

Active strategies however employ an investment manager, and often researchers too, so the costs are higher, reflected in higher fees.  Decisions on what to hold and when to buy and sell are at the discretion of the investment manager.  Returns might be very different from overall market returns.

Which strategy is better?

There is a significant body of research that suggests that for large developed markets, most (but certainly not all) active fund managers struggle to beat the market consistently after fees. 

Why is that the case?  Well one of the explanations is that there are always a small number of “winners” in markets – stocks that will increase in value massively in a short time period, and in so doing, help to raise the performance of the market overall.  However, in markets with literally thousands of stocks (think North America or Europe), identifying the winners is very, very difficult.  Active managers effectively try to do this, but often do not succeed.  Or if they get it right one year, they may not get it right the next year.

Passive funds however, because they invest in the entire market, always get the “rising tide” benefit of owning some of the winning stocks.  Over time, this seems to give passive funds an edge over most actively managed funds, especially when fees are also taken into account.

But what about smaller markets like New Zealand (and Australia to a lesser extent)? 

Because of the smaller overall size of the market, I contend that it is far easier for good investment managers to identify the winners, and also to avoid the losers.  This is one of the reasons why I prefer an active management strategy for NZ (and to a lesser extent Australia) equities.  The other reason is that the fees for NZ passive funds are very high compared with equivalent international passive funds (eg. NZ SmartShares fees are ~0.5%), so the fee advantage for passive funds is diminished.

To back up my assertion, I have been monitoring the performance of two of my preferred actively managed NZ/Aus funds, compared to investing in a 50/50 mix of available NZ/Aus passive index tracking funds.  So far, after fees, the actively managed funds are outperforming the index tracking funds by healthy margins for 1 year, 3 years and 5 years (as far back as my data goes) – they are more than 30% ahead of the passive fund mix in each category. 

The scale of my research isn’t big (its unlikely to be featured in any investment white papers!)  And I am only looking at two of my preferred active funds, not all active funds.  But it does highlight that there are nuances to the active v passive debate: the size of the market is important, and the level of fees charged (especially for the passive funds) also matters. 

 

Dean Edwards

 

Active v Passive – which is better?

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