What's the difference between active and passive investing? Is passive is better, especially for KiwiSaver?
What is passive investing?
Passive investing is when a manager invests your funds according to a set of rules (typically following an index) rather than actively selecting individual investments. A core premise of passive investing is that investments are held for the long term rather than being active traders trying to time markets or make active decisions around when they do things.
What is active investing?
Active investing is when a portfolio manager will review and individually select each individual purchase decision. The active portfolio manager will conduct detailed research to identify and select the best individual investments and then identify the best timing to buy and sell those investments. Under this approach of investing, you are relying on the portfolio manager to make the right decisions to outperform the market.
Is there a cross over between active and passive investing?
The difference between active and passive investing is becoming increasingly blurred and don't be mistaken in thinking that your passive manager is simply relaxing in the office with his feet up. A passive investment manager makes decisions around asset allocation, currency and what index to cover. These decisions account for over 90% of returns. What they don't do is individually research companies and make decisions around timing when to buy and sell into those individual companies.
Increasingly, the range of passive investment funds is expanding to allow specific investment styles and factors to be taken into account, which further blurs the lines. For example, kōura’s US Equity Fund; we acquire a passive investment product that also includes exposure to smaller companies and takes into consideration Environmental, Social and Governance Factors.
Why is passive investing a good thing?
Fundamentally – passive investing is better for investors as it typically delivers investors better post fee returns.
Global research consistently shows that active investors consistently underperform the markets. Each year, S&P releases a paper comparing average actively managed fund returns versus the equity benchmarks (the returns a passive manager would have earned before fees) and over a 5 year period the average mutual fund in the US market would have outperformed the S&P Composite Index by 2.4%.
When we compared New Zealand KiwiSaver growth funds versus their stated benchmarks we saw that no KiwiSaver growth fund had beaten its index over the past 5 years and in fact, the actively managed growth funds had underperformed by an average of 0.9%.
Importantly, international research has shown that it is infrequent for a fund manager to outperform the market over a long period of time continually. Strategies and people within a fund might perform in certain market conditions, but the inevitable change and it is very rare that an active manager will outperform over time.
A passive fund will typically perform in line with their benchmark less the fees. The average passive fee for a KiwiSaver portfolio is 0.67% (the kōura fund are priced at 0.63%). Therefore we would expect a passive fund to perform above the average KiwiSaver growth fund, and this performance will be consistent. People changing jobs and moving to other funds or fund managers changing their strategies on how they invest no longer things you need to look out for.
Warren Buffet is arguably the most famous investor in the world and the worlds' third-richest man. He is a huge fan of passive investing. In 2007, he took a $1m bet that a passive investment in the S&P500 would beat a portfolio of hedge funds (supposedly the crème de la crème of active managers). Over the 10 year period, the passive investment delivered a return of 7.1% per annum vs the hedge fund selection, which only delivered a 2.2% return.
How will a passive investment portfolio perform in a downturn?
A common theme from active investors is that passive funds will underperform active funds in a downturn. The truth is that yes, passive funds will do worse in a downturn. However, we agree with Craig Lazzara, Managing Director for Investment Strategy who says, “The data we have on this topic suggests that active managers can do somewhat better when the market is declining, but certainly the majority do not do better”. In fact, a recent US research paper shows that US Active Mutual funds underperformed the US market through the global financial crisis (1/1/2008 – 31/12/2010) by 1.0% per annum.
In the New Zealand context, NZX Smartshares (another passive investor) assessed the performance of New Zealand equity orientated active fund managers and saw that they too underperformed their benchmarks during this period of heightened volatility.
Conclusion
We are confident in our decision to be a passive KiwiSaver fund manager. We think that this will deliver the best returns over time for investors, and this is particularly relevant for KiwiSaver where investment horizons tend to be really long.
It is estimated that 16% of all equity investments are now held in passive investments, up from 12% in 2014, this growth shows the growing confidence of the investment universe in passive investments.
Still, have doubts? Here’s a letter we wrote to our Active Fund Manager friends recently, which shares more data and research on why passive is the way to go!
The kōura difference
The kōura KiwiSaver scheme is passive; we offer investors the opportunity to invest in one of six separate investment funds, all important components to create a balanced portfolio. We ask you a simple set of questions to understand your goals and assess your risk appetite and then generate a portfolio that's entirely personalised for you. Our calculators allow you to see just how much you will have in your KiwiSaver balance based on what you're saving now and will even give you a weekly retirement income prediction. This enables you to get a realistic picture of much you can rely on your KiwiSaver fund for your retirement and what levers you can pull to give you the retirement you want. Give kōura a try now and see what your retirement will look like.
