NEWSLETTER
Understanding the
active and passive
investment styles
• No detailed analysis
•A
ims to replicate the performance of
a market
ACTIVE
• Fund manager conducts rigorous research
• Aims to beat the market
• Maximise gains and minimise losses
When investing one’s money, one of the choices facing investors is an active or passive investing style.
It is important for an investor to understand the main principles of each style before determining
which one – or a combination of the two – is most suitable for their particular investment objectives.
This fact sheet sets out to explain the differences between these two investment styles to aid investors
in their discussions with their financial adviser on choosing the most suited approach.
FUNDamentals
DISCOVERY INVEST
Passive investing
Passive investing or index tracking refers to when investors buy a
fund that follows the performance of a given index. For example,
if one wants to have access to the FTSE/JSE Top 40 Index, investors can
buy into a fund that tracks the performance of the index by owning a
representative sample of the total shares on the FTSE/JSE Top 40 Index.
The “fund” that one invests into is either a unit trust fund that is set
up as an “index tracker” or, more commonly, an Exchange Traded Fund
(ETF). An ETF tracks the performance of a given index and provides
investors with the returns – positive or negative – of that index.
In addition to tracking an entire index, ETFs can also track a component
of an index, such as only the top shares, financial shares, or only
industrial shares.
Index-tracking funds have been available since the 1970s in the US and
are now widespread globally. Each fund attempts to index or “track” a
particular index or portion of an index. ETFs are a relatively “new” fund
vehicle, having been available for the last 10 years. Ultimately, however,
each fund is aiming to do the same thing – track the performance of
a given market.
An important overriding principle of index-tracking or passive
investing is that it’s a strategy designed to match a market, not beat
it. The performance of an index-tracking fund or ETF will mirror the
performance of the index or market it is tracking. Therefore, if the
FTSE/JSE Top 40 Index performs positively, for example, the ETF
tracking the index will produce a positive return. The ETF will produce
a negative return if the index performs negatively.
The manager of an index tracker or ETF acts very much as a financial
adviser – accepting instructions from investors to buy or sell a given
percentage depending on how much they want to invest. When a fund
invests in a component of an index, the fund manager is responsible
for “rebalancing” the portfolio in line with changes in the shares of the
index. Due to the fact that these funds track an existing index or market,
the input required from the fund manager is relatively small, hence this
investment style is known as “passive investing.”
In South Africa, investors have access to several ETFs that track
different components of the market. To name but a few, investors
can track:
• An index that constitutes the 40 largest companies, by market
capitalisation, listed on the JSE Securities Exchange.
• The top 15 financial institutions in South Africa, including the
country’s five largest banks, other general financial companies,
property companies, plus the main long-term and short-term
insurance companies.
• Resources-based stocks, including mining companies, mining
holding companies, mining finance and exploration companies
and resource-based stocks, such as Sasol.
While a fund manager’s role in managing an ETF or index tracker fund
is “passive”, the role of the fund manager in the “active investing” style
is somewhat different.
Index tracking, or passive investing,
is a strategy designed to match
a market, not beat it.
FUNDamentals
DISCOVERY INVEST
Active investing
Active investing is when one invests in a fund that is “actively
managed”. Active fund managers seek to beat the market’s returns as
opposed to only giving investors a replication of the market’s returns
as seen with index-tracking or passive investment funds.
Active fund managers seek to
beat the market’s returns.
Managers following an active investment style use various
methods to outperform a given index or benchmark. The essence
of their approach is to capitalise on what they believe are pricing
inefficiencies in the market. They conduct detailed research on
companies and stock prices and compare their valuation of those
stocks to that of the market. The majority of this analysis includes
evaluating a company’s past, current, and future earning capability
with forthcoming business and economic conditions. The outcome
of their analysis is compared to the company’s past, present, and
forecasted stock price. The manager’s intention is to buy a company’s
stock when they believe it is undervalued, and to sell that stock
when it is overvalued, thereby creating a profit for their fund.
Managers will also attempt to identify economic trends to help them
predict which industries have the best near term prospects and avoid
those with a less favourable near-term outlook.
Investors have a plethora of actively managed investment funds
to choose from in South Africa and internationally. The range of
actively managed funds includes equity funds, bond funds, balanced
funds, specialist funds, global funds and emerging market funds. For
each type of investment strategy, fund managers follow a detailed,
methodical research process to identify and choose the stocks that
they believe will provide the greatest performance within their
fund. Actively managed funds aim to beat a market or an identified
benchmark.
Comparing the two investment styles
When one aims to compare active and passive investment styles, one has several important factors to consider, such as the level
of fees and the expected risk and returns of each investment style. The investment decision-making process requires more time
and resources for active managers, and as such, they typically have higher management fees. However, the manager’s success
may vary and typically results in more volatile investment returns relative to the index.
Conversely, passive or index-tracker managers typically charge lower management fees for a more simplified investment process
of matching the returns of an index. For the active style, the risk is more manager-driven while for passive investing, the risk is
more market-driven.
Given the nature of the investment styles, index-tracking investors are always fully invested to the index (or component of
the index), meaning the portfolio will hold a proportion of just about every stock in the index and little to no cash as an asset.
This subjects the portfolio to market swings, which proves rewarding during market upturns, but costly during protracted
market declines.
Active managers on the other hand, vary the type of stocks and amount of cash held in the portfolio based on their opinion
of market conditions and stock prices. These are typically rewarding during market upswings, and can be less costly during
market declines.
FUNDamentals
DISCOVERY INVEST
Differences between active and passive investing
Fund
manager
Active investing
Passive investing
•Conducts rigorous research and analysis on
company stocks.
•Fulfills a “passive” management role.
•Makes informed investment decisions for
the fund.
•No detailed analysis or significant investment
decisions required.
•Fulfills an intensive management role.
Performance
•Aims to beat the market or beat a stated
benchmark.
•Has the ability to maximise gains and
minimise losses.
Fees
Risk
Strategies
•Does not aim to beat the market or a benchmark.
•Aims to replicate the performance of a market –
positive or negative.
•Cannot make gains greater than the market.
•Manager fees are higher due to increased
levels of skill, knowledge and involvement
required on behalf of the manager.
•Lower management and operating fees.
•Fund is exposed to manager risk as well as
market risk.
•Fund is exposed to market risk.
•A range of strategies for investors to choose
from including equity funds, bond funds,
balanced funds etc.
• No choice of investment strategy.
Many studies have been performed to test whether one particular investment style in terms
of active versus passive investing has proven more successful. Conclusive evidence has not
been determined to support either strategy in totality. However, it should be acknowledged
that both strategies have appealing characteristics and have seen varying degrees
of success based on certain economic conditions, market types, and time
periods. Moreover, the suitability of either investment approach, or
a combination of the two approaches, is based on one’s personal
investment objectives and circumstances. Your financial adviser will
be able to recommend investment funds that are suitable for your
needs and that best fit your specific risk profile and investment
objectives.
GM_16246DI_27/06/2012