Firstly, let’s clarify the difference.
A passively managed fund is designed to minimise decision-making and keep costs down. The most common types of passively managed funds are index funds, which replicate the movements (and therefore returns) of a particular benchmark index. These funds are set up so their performance will effectively mirror that of the index – meaning the fund won’t outperform the index, but won’t underperform it either.
An actively managed fund aims to outperform a particular index or benchmark over a defined period of time, with a portfolio manager using research and expertise to select individual securities they believe will perform best. There is also, therefore, a risk of underperforming the benchmark.
What sometimes gets lost in the argument of ‘which is better’ is a genuine understanding of the different approaches – and, importantly, how they can both benefit you as an investor at different times.
In a constant effort by investors to reduce fees, the popularity of index funds is understandable. But in a world where performance is becoming harder to come by, an actively managed fund – where investment choices are based on analysis, research, and market knowledge and experience – might be a more attractive option.
When deciding on an investment approach, there are three important things you should consider.
1. Your objectives
If you’re looking for a market level return and you’re comfortable with the characteristics of a particular asset class and its benchmark (such as the ASX300 for Australian equities), an index fund could suit your requirements. In terms of performance, whatever the market does is what you’ll get – there’s no flexibility around this.
If you want to try and outperform the market, need a particular style of return (such as income), or have a bias towards a particular characteristic or type of stock, then you could consider an actively managed fund.
2. Fees
There are no active investment decisions involved in managing an index fund, so a comparatively smaller investment team is required. As a result, index funds usually have a lower management fee than actively managed funds.
In an actively managed fund, the investment team will usually conduct assessment and analysis of individual shares as well as the broader economy and other relevant factors. Given the resources involved in this, and the fact that an active manager expects to outperform its benchmark, actively managed funds tend to have a higher cost than index funds.
In the drive to reduce fees and get ‘value for money’, investors can sometimes become hung up on the investment’s cost rather than its outcome. Make sure your investment strategy is aligned to your goals, and you understand the difference between price paid and value received.
3. Investment manager
Because it only ever matches an index, an index fund will essentially always do what it says on the tin. If the index goes up, performance goes up, and vice versa.
But when it comes to choosing an active manager, not all funds are created equal. This is also why it can be hard to compare the performance of active and passive funds: there are wild variances between active managers, styles, investment approaches, risk, etc.
Do your research when it comes to a manager’s style, process and philosophy. Do you understand how the fund is managed? Are you clear on what it’s aiming to achieve? Above all, though, always remember that past performance is not an indicator of future performance – one of the most important rules of investing!
There’s no doubt that the debate around ‘active versus passive’ will continue. But, as with all investments, the key for investors is to be clear on what your own purpose or objective is, and then select the funds that best align to achieving your goals. It doesn’t have to be either/or – adopting an investment strategy that combines active and passive elements may in fact deliver the best of both worlds.
The content contained in this article represents the opinions of the author/s. The author/s may hold either long or short positions in securities of various companies discussed in the article. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the author/s to express their personal views on investing and for the entertainment of the reader.
