Active vs passive: the great investment debate

confused adviserFinancial advisers are constantly debating the pros and cons of whether it is better to be active or passive with an investment portfolio. The debate has raged for years and is likely to continue for years to come. Many financial advisers and institutions stake their reputation on one philosophy vs the other and go to extraordinary lengths to convince clients that their belief is the right one. At Milestone, we believe there are merits in both active and also passive investing and we will use either philosophy when we perceive it is in the best interests of our clients.

Active investing is where financial advisers select funds where the manager uses their skill and experience to buy investments they believe will outperform the market. These managers may follow a benchmark asset allocation or else they can alter their asset allocation depending upon their view of the market. Passive investing is where financial advisers select a fund which mirrors the market index. The manager simply buys the market as opposed to “picking what they regard as being the best in the market”. Passive investing means investors need to ride the ups and downs of the market in the belief that over time, their portfolio will end up being in positive territory. Active investing assumes that a high quality manager is used – one who has the skills to minimise losses and maximise gains. Typically, active management is more expensive than passive as the manager needs to do more research on what to buy and when to buy and sell it.

There is no denying that in the USA, there is an increasing trend towards passive investments. This is largely due to the massive size of the US investment market and the ability to purchase passive or index funds at extraordinarily low prices. Combine this with the indices being nicely diversified and having plenty of liquidity and passive investing makesperfect sense. In New Zealand and Australia, passive investing is starting to become more popular but is hamstrung by fees not being anywhere near as low as what they are in the USA, plus our share market indices are heavily concentrated into a few large stocks which are susceptible to exchange rate and economic fluctuation.

An independent research report from NZ Trends titled “Active versus Passive Investing- analysis of multi-sector fund performance” (June 2015) concludes “that the average actively managed growth, balanced and conservative multi-sector funds have outperformed the corresponding passive fund average. Active managers produced better results during the Global Financial Crisis while asset allocation flexibility inherent in active multi-asset funds appears to have been beneficial. The results are close and over longer time periods the performance advantage could shift cyclically. Although passively managed funds can claim to have lower management fees (on average) they cannot claim performance superiority over the period under review. When tax was taken into account the advantage to active funds increased slightly.”

At Milestone, we are watching with interest the reduction in fund management fees. As a starting point, we tend to use active managers with lower fees and historically proven good risk adjusted returns. This has seen our clients benefit over passive investments in recent years. However, as New Zealand becomes more internationalised, we are anticipating that lower cost passive funds will appear in New Zealand and this will prompt us to consider their use in some asset classes and at some stages of the investment cycle.