What even are passive and active investing?

21 May 2020

Passive investing is like hopping in the car and following a well-worn route to get to work in the morning. You know where you’re going, there might be the odd traffic jam, but you can have faith it’s going to get you to work quicker than most other routes. Sound exciting? Didn’t think so. That’s the point. 

Passive investment managers manage your funds according to a set of rules rather than trying to make guesses at individual investments.  Typically they will invest in products that simply follow the markets rather than trying to take bets on individual companies or market timing.  Markets are notoriously difficult to predict and very few people can consistently pick what they will do next.  Research shows you are better off taking the market return rather than trying (most of the time unsuccessfully) to beat it.

Active investing on the other hand is what happens when you try out one of those new-age trip planning apps; you’ll take your car, an e-scooter, and two Auckland Transport buses to try and arrive five minutes early. You might get there early, though probably, you will miss that first meeting. 

An active portfolio manager should review and individually select each individual investment.  The active portfolio manager should conduct detailed research to identify and select the best individual investments and then make the call on the best time to buy and sell the investments.  Under this approach of investing, you are relying on the portfolio manager to make the right decisions to outperform the market. Given the amount of work required, the manager will charge significantly higher fees for doing this. 

 

Is my passive manager just sitting around all day?

Despite the name, passive investing doesn’t mean your fund manager is laying back in the office online shopping. A passive investment manager is constantly making important decisions around asset allocation, currencies, and what index to cover. These decisions account for over 90% of returns. What they don't bother with, is research individual companies or try to time the market (because the research tells them they will be unsuccessful at this). 

Increasingly, the range of passive investment funds available is expanding to allow specific investment styles and factors to be taken into account which further blurs the lines. For example in kōura’s US Equity Fund, we own a passive investment product that also includes exposure to smaller companies and screens companies to ensure we only invest in ones that meet strict sustainability criteria.

 

Is active investing really bad?

The short answer is yes. The state of New Zealand’s egregiously underperforming active funds can be best seen when we look at the last five years of Kiwisaver growth funds. Looking at individual fund updates, no KiwiSaver growth fund had beaten its index over the past five years and according to Morningstar the actively managed growth funds have underperformed by an average of 1.4%.

Even if you are lucky enough to find a fund that outperforms, it is very rare for that fund manager to outperform the market over a long period of time (less than 15% of top performers outperform for consecutive 5 year periods).   Strategies might perform in certain market conditions, but often these are rare glimpses of sunshine — like your mate that might have had a good run at the casino. It’s incredibly rare for an active manager to outperform the market over time. 

On the flip side, a passive fund will typically perform in line with their benchmark, less the fees. The fees are usually far lower, too. The average passive fee for a KiwiSaver portfolio is 0.67% (the kōura funds are priced at 0.63%), therefore investors can expect a passive fund to perform above the average KiwiSaver growth fund, and this performance will be consistent as we are not gambling and trying to beat the market. 

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 (this period included the GFC) vs the hedge fund selection which only delivered a 2.2% return.

 

But people reckon active’s better in a downturn?

A commonly touted myth from active managers is that passive funds will underperform active funds in a downturn. There’s a modicum of truth to this, with some prized active funds managing to weather the storm better, but it’s also far from a hard and fast 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 — these tend to be the facts avoided by the smooth-talking managers of these active funds.

Most importantly though, at kōura, our passive strategy is performing through the current Covid-19 market volatility.  According to fundsource, a portfolio of kōura funds representing a growth fund (80% growth assets) would have been one of the better performing growth funds in the market in the period to the end of April 2020.  It shows great asset allocation beats stock selection any day of the week!

 

Why kōura picks passive

We are confident in our decision to be a passive KiwiSaver fund manager.  We initially chose to be a passive manager based on the extensive research showing the benefits it gives everyday investors.  As always, we are really happy to see that our results reflect the research, and our portfolios are some of the better performing portfolios through this market volatility. 

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!

If you want to chat/debate the benefits of passive investing don't hesitate to drop our founder Rupert an email.  He is passionate about passive and will explain to you why.

Download Today