INVESTOR EDUCATION – Active vs Passive Investing
The debate between passive and active investors has gone on for decades, and we aim to explain the key
features of both approaches. While we believe there is a place for passive management, our investment
philosophy is very much active. In particular we aim to be out of the market during periods of significant
decline, in order to preserve capital and meet our goal of generating positive returns.
What are the two approaches to investment?
Before going into the argument for active investing, it is important to highlight what we mean by passive and active management.
Passive Investment Management
Over the past couple of decades, index-style investing has become a popular strategy
for investors who are satisfied by duplicating market returns instead of trying to beat
them. Passive, or index-style investments, buy and hold the stocks or bonds in a market
index such as the ASX 200. There are plenty of indexed mutual funds and exchange-
traded funds (funds listed on the share market which track the performance of a
market index) which track the broad market as well as narrower sectors such as small-
company stocks or specific industries.
Passive investment management makes no attempt to distinguish attractive from
unattractive securities, or forecast securities prices, or time markets and market
sectors. Generally passive investors will use exchange traded funds (ETFs) which are
funds listed on the share market which track the performance of a market index.
There are some key advantages of passive investment 1) Passive funds generally have
low fees, 2) there is a high level of transparency – because investors know at all times
what stocks an investment contains.
While we believe there is a place for passive management, our investment philosophy
in particular would prefer to be out of the market during periods of significant decline,
in order to preserve capital.
Active Investment Management
Active management varies to degrees (see our article Explains Absolute Returns),
however in general the aim of active management is to outperform the broader market and add value for investors.
There are 2 key ways in which active investing can add value:
1) Security Selection – this refers to aiming to buy stocks which will perform well (and better than the market) and selling or not owning stocks which will perform poorly.
2) Tactical Timing – this refers to moving between different types of assets, depending on the portfolio manager’s view. For example, an active portfolio may hold cash if the manager believes share markets are set to fall, and wants to avoid downside.
This leads to the first significant advantage of active management – the potential to
preserve capital. Studies have shown that avoiding significant downside events is the
biggest contributor to outperformance over the long term. The recent Global Financial
Crisis (GFC) was a prime example where many fund managers saw it coming, and
allocated heavily towards cash rather than shares. This action saw these funds avoid
significant downside and outperform the broader market.
US Share Market – S&P 500 During Financial Crisis
Other advantages of Active investment include:
Flexibility – because active managers, unlike passive ones, are not required to hold specific stocks.
Hedging – the ability to use options and other strategies to insure against losses
Risk management – the ability to get out of specific holdings or market sectors when risks get too large, or the outlook on a sector is seen as unfavourable.
An Example – The Australian Model Portfolio
At, we believe performance means making money for our members and the
foundation of our investment philosophy is to generate absolute positive returns for
our members. As such we are very much believers in Active Management, and this
means that at times the holdings in our fund may significantly differ from the broader
equity market. Below we have shown the sector weightings of the ASX 200 index, which
represents the biggest 200 listed companies in Australia
Source: ASX
There is a very large weighting to Financials in the market index (47%), made up
predominantly by the 4 major banks – ANZ, CBA, NAB, and Westpac. Our view is the
outlook for the big banks is mediocre at best, and as such we hold none of the big banks
in the portfolio. Of the Financials we do own, we are still underweight, with only 20%
of the portfolio in financials, as we presently hold one regional bank, an investment
bank, and an insurance company. Another sector that we are underweight is Materials,
and overall we are not focussed on the index when constructing the portfolio.
We also have the ability to hold cash in the portfolio (currently 30% of the portfolio is
held in cash) when we believe it is appropriate in order to avoid downside.
This approach comes with the risk that our returns will not follow the returns of the
broader market, however our investment philosophy prefers an absolute return
approach.