Passive Investing versus Active Investing
In this third instalment of our journey into managed funds and exchange traded funds (ETFs), I explain in more detail the difference between passive funds and active funds.
The passive versus active concept is a building block in understanding the investment landscape. More so today as the investment world continues to evolve and provides us with more investment options. A good example is the rise of rules-based funds and thematic funds, which are variations to the passive and active concepts.
But first, back to basics. What are passive investment funds and what are active investment funds?
Passive funds can be considered those funds that give you access to a share market index. The index can be a country’s share market index. An example in Australia is the S&P ASX 300. This is an index of Australia’s top 300 stocks and includes the likes of the big banks, BHP, Telstra etc.
There are many investment fund providers that can give you access to such funds. Vanguard is a very well know investment manager who specialise in this area. The Vanguard Australian Shares Index Fund replicates the S&P ASX 300. That is, it gives you access to the top 300 Australian shares in one investment.
It also does the same for other countries. You can invest in a global fund which replicates the Morgan Stanley Composite Index International Shares fund. This index monitors the top 1,500 global shares, or you can be more specific by investing in an index of the top 500 US shares.
The list can go on, but the main point is that even with basic passive investing there are options aplenty. The main questions are what could drive an investor to use index funds rather than consider other active or complex funds. Some reasons include:
Simplicity – you know what you’re getting. Investing in the Vanguard Australian Shares Index fund replicates the index for the top 300 shares. There’s no deviation from this unless the index changes,
Cost – investing in index funds is far cheaper than investing in active managed funds. The Vanguard Australian Shares Index fund costs 0.07% which is $7 for every $10,000 invested (compare that with a fund that charges 0.6% which is $60 for every $10,000),
Stock market rate of return – investing in an index means you are generating the same return as the stock market you are invested in. We looked at rates of returns in the previous post. We know that over the past 10 years Australian shares have return on average over 8% a year (and over 9% a year on average if you go back 15 years). An index of global shares has averaged over 13% a year for the past 10 years. For many people, this is a good rate of return for keeping your investing simple enough.
Having stared with the idea of passive investments, we now briefly introduce active managed investments. Active management refers to those investment professionals who have a certain investment philosophy or certain investment knowledge and skills that can create a better investment outcome for investors.
We mentioned the rates of returns above and in our previous post. Active fund managers would benchmark themselves against a main index so we can judge their performance. Beating their benchmark index is therefore one main reason you would look to consider an active fund.
Whether active fund managers can beat their benchmark index over a long-term is a topic for a future post.
For the moment though I would like to highlight some of the benefits of considering these investments as some managers can outperform in the short and intermediate terms.
Active fund managers do bring some diversity to your investment portfolio. Taking active Australian funds as an example, most active managers would restrict their portfolio to 30 stocks or 50 stocks. This compares to 300 stocks for an index fund. The active manager is looking to concentrate their portfolio in stocks that may outperform.
They also have the flexibility to make changes as the economic environment changes whereas index funds do not have this option. Index funds must always remain invested. Having such options combined with the skills and knowledge of the investment manager, can lead to increased returns.
One other aspect that I have come to consider important is knowing the fund manager. We’ve mentioned Vanguard in this post many times already. Vanguard was a pioneer in the managed funds industry over 50 years ago. Their goal was to bring managed funds to investors with easy access and at a much less cost, a goal easily achieved.
There are many other popular investment managers, and we’ll introduce some of the names in future posts.
