Active or passive - does it really matter?

Active or passive - does it really matter?

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Article highlights

  • Passive, or rules-based funds have gained popularity over the last ten years
  • Investors have a tendency to want to chase returns and choose funds based on the most recent returns
  • The key when looking for a fund to invest in – both rules-based and active, is diversification

As the effects of the global Covid-19 pandemic continue to take their toll, many people are scrutinising their investment strategies and wondering what, the best approach is, especially when it comes to active and passive investing.

Is one better than the other – and if so, in what circumstances? This topic was discussed at the third Take 5 event hosted by Maya Fisher-French, independent financial commentator.

You can listen to the full conversation on Google Podcast, Apple Podcast or Spotify, or read a summary of the conversation below. You can also watch the webinar on YouTube.

What is the difference?

Passive investments track an index – for example the JSE. Active fund management is where a fund manager is taking real positions and putting their reputation on their skills in finding value.

The rise of passive (rules-based) investing

Passive, or rules-based funds have gained popularity over the last ten years – led by US investment firms Vanguard and BlackRock, especially as the focus on costs and fees as increased and investors have been looking for lower-cost products. Many investors have been indicating that they are happy to just get the return of the market rather than pay an active fund manager.

The argument around active and passive has come under the spotlight due to the underperformance of a lot of active managers – which has brought the average performance of active managers down.

Passive investing is now known as rules-based investing because the term passive investing is a misnomer. Even passive investment into funds that track an index requires an active decision. An index is fundamentally a theoretical construct. It is not something one can invest in directly and it needs to be replicated by investing in the underlying shares that makes up the index.

The index merely provides the rules to follow in weighting the underlying holdings. The key to harnessing some of the benefits highlighted above is how well one can implement the strategy. This requires bridging the gap between theory and reality.

The Covid-19 effect

Choosing a fund has become even more difficult for investors. How do you know which fund will do best? Individual performance in a fund is dramatically affected by investor behavior. Investors have a tendency to want to chase returns and choose funds based on the most recent returns. However, because the return of different funds can be so varied – both over time and relative to each other – trying to time the market and making decisions based on past performance can lead to very damaging financial consequences. This is even more apparent now because of the effect of theCovid-19 pandemic on fund returns.

The one-year performance figures for South African Equity Funds to July 2020 show that the best performing fun returned +24% while the worst performing fund over the same time frame returned -34%. Past performance of either of these funds would have given no clues as to this huge diversion of performance.

One of the biggest challenges of active fund management is trying to predict who will perform best. Active managers by their nature take bets away from the index which means that they will over and under-perform at times. Investors must be cognizant of this and the risk that mangers are taking in a fund as this might affect performance.

A concentrated portfolio means that as an investor you are more exposed to the risks of that particular stock or industry which are sensitive to the effects of single events. The huge divergence in the performance over the last 12 months has been particularly due to specific industries being affected by the Covid-19 pandemic.

However, good managers who stick to their investment process and have the resources and expertise should be able to outperform the market over time and investors must be prepared to sit out the volatile times.

Rules-based funds were also not immune to the Covid-19 effect but felt it to a lessor extend. The emergence of factor-indices has also led to much more divergence in the performance of rules-based funds.

Diversification remains the key

The key when looking for a fund to invest in – both rules-based and active, is diversification. This has also been highlighted recently where certain industries and sectors of the market have come under extreme pressure. Within these sectors, the businesses that have succumbed have been the businesses that were already under pressure with stretched balance sheets – and a good active manager should be able to discern, and avoid, these companies.

Diversification means having both active and passive/rules-based investment styles in your overall investment portfolio. It also means having investments across a range of companies, geographies and industries.

Balancing offshore and domestic diversification is also a crucial consideration. Global investing always makes sense as it gives you full exposure to the whole market and you are not limited to the local market. However, the reason for moving money offshore should not be because things at home are going badly. Rather, it should be a strategic call to achieve real diversification.

The South African market makes up less than 3% of the global market so we are very susceptible to currency risk. This means that investors need to be aware of how much of their assets they need to have access to in the short term – and this portion should be invested locally to avoid currency volatility.