Do you prefer an active or passive fund manager?

There are typically two styles of fund managers: active and index (or passive).  An active manager tries to beat the market by picking and choosing investments that aim to outperform a benchmark index, such as the S&P ASX300 index. Index managers take a more passive approach and aim to replicate an index’s return. They do this by tracking the returns of the index they follow by buying most of the holdings in that index. In other words, they replicate the index by purchasing most, if not all, of the holdings in the index and don’t need to perform any individual stock analysis. Because index funds are not employing teams of investment analysts and economists, they can provide funds at a lower cost to investors, typically with fees of below 0.20%. The negative is that they never actually beat the index.

Because active managers aim to outperform the market, their funds typically have a higher fee – usually around 0.8%-1% – to compensate for the extra work required to achieve the potential higher returns. This work includes more in-depth analysis of the balance sheets and earnings of each stock, economic forecasting of factors that may influence a stock’s earning, such as interest rates, currency movements or commodity prices, such as oil and gold and determining which sectors will outperform. If a manager is charging above 1%, investors need to ask why or consider a more cost-effective alternative. Research shows that most managers underperform the index, therefore investors need to ensure they are not paying active fees for index underperformance. Typically, you would want to see your active managers beating the index after fees over three and five-year periods. Short-term volatility is typically a bad indicator of long-term performance but should raise the question as to what has caused it. Most fund managers release quarterly fund updates, which should explain how the fund is tracking against its index.

Index funds tend to be more tax efficient when compared with active funds. This is because an active manager buys and sells investments more frequently than an index manager in order to achieve higher returns. This comes at a price – namely taxable capital gains, which is passed onto the investor.

While passive investing might sound a little “dull”, a passive approach can be applied to any market or asset class with an index to replicate – from equities, bonds to commodities – the same as for active investing. However, there are some areas of the market where an active approach makes more sense.  Examples include Australian small company funds where active managers regularly beat the index and direct property where there is no true index.

Choosing an approach for your own investment needs comes down to what suits your investment goals and how comfortable you are with risk. Perhaps your needs might require both an active and passive approach. With active managers you need to consider the level of outperformance you expect from them; the cost of choosing to be in an active fund as opposed to a passive one; and your own tolerance for taking on the risk that they may underperform the index. With any active manager there will likely be times when you will be paying for underperformance so you need to be comfortable with this and be patient and prepared to move your funds if the outperformance continues.

Once you choose to invest in an active fund you have a range of investment styles to choose from. The two major styles are value and growth. Value managers will look to invest in stocks with strong and growing revenue streams. Growth managers will be looking for companies with a growing market share or product range from which earnings will emerge. At different stages of the economic cycle these managers will perform differently. In times of strong market euphoria, the growth managers will typically outperform. It is important to understand that each manager’s investment philosophy will lead to times of over and underperformance, hence a blend of different styles will contribute to your portfolio diversification and should reduce its volatility accordingly. Regardless of the investment style, fund manager’s will still need to be able to pick the best performing stocks to deliver index outperformance.

Most investors will base their investment decisions on performance alone and this is their most common mistake. Last year’s winners can quickly become next year’s losers and looking beyond returns to understand a manager’s investment philosophy and building a portfolio of complementary managers should lead to better long-term outcomes with lower volatility of capital.

Another way of gaining exposure to a range of fund managers with different investment philosophies is through Centuria LifeGoals investment bonds. Centuria LifeGoals include a range of asset classes and diversified funds such as specialist low-cost index funds and high-quality complementary active investment managers. Unlike investing in managed funds directly and paying tax at your marginal rate, which may be as high as 47%, funds invested in LifeGoals have their earnings taxed at 30%. The product gives investors one simple solution that covers tax planning, investment and estate planning needs.

Unlike owning managed funds directly, you can invest in managed funds via Centuria Lifegoals and switch between managers with no capital gains tax consequences. Centuria will also review the selected managers on an ongoing basis to monitor whether they are meeting their investment objectives as set out in the product disclosure statement.