Passive investing or trading is a cost effective way of investing in the stock market. It outperforms active investing or trading in Australia more than 70% of the time.

Passive investing is when you place your money into funds which ‘track the index’ or a benchmark by having a large range of shares thereby avoiding the ups and downs produced by individual companies doing very well or poorly. Your investment will go up or down in value with the stock market or benchmark as whole and not with one or a handful of companies. You can choose to ‘track’ the top 20 or 200 companies, or various categories such a small to medium companies, large companies, fixed interest companies, mining or real estate companies to name but a few.

Active investing is when you might choose 5 or 10 (or whatever number) of companies to invest in believing you can pick which companies are going to be very successful. In addition to picking which companies to invest in, active traders also have to pick when to get out and sell. Most of the active investors in Australia are fund managers, although there are a number of individual investors who enjoy investing actively or have made a career of it, such as for example Warren Buffet in the United States. Over 95% of trading activity is done by active traders.

Below is a chart showing the extent to which passive investment in indexed funds out-performs funds managed as active investments (most of the time).

Why is this so?

The overall return of all trading activities, both passive and active, equals the index. For one active fund manager to outperform the index another must underperform the index, because the index represents the average return. The return to individual investors in such funds is the return that fund makes less the operating costs of that fund. As active investing is costlier than passive investing, because the costs of market research and the costs of more frequent trading increases the costs, actively managed funds more often underperform their passive counterparts, if all funds in the two groups are compared.

This is one of the reasons why in the above table passive indexed funds out performed active investing. However it does not mean passive investments out perform all active investments. Some active fund manages consistently outperform the index while others do not. If you invest in active investment funds the trick is to select which fund managers will outperform the index. That is not easy to do as last year’s high performer can easily be this years, or next years, underperformer.

Given this reality, it appears that the best predictor of how well a fund will perform in relation to the index is how high the running costs of the fund are. Numerous studies, notably those by Morningstar and McGraw Hill’s SPIVA report cards support this.

So where’s the value?

As you will see from the table, the one bright spot among the active investment funds, in Australia at least, is in investing in small to mid-cap companies. They have outperformed their benchmarks by 3.1% and 4.8% per annum in the past three and five year periods respectively. However this is not the case in most overseas markets where active investors, as a whole, did not outperform the index.

Outside this group of funds investing in small to mid-cap companies in Australia, underperformance is the norm over all time frames.

Are active investor fund manager’s hands tied?

Fund managers exist in a life cycle much shorter than what could be deemed a reasonable investment time frame. When your job performance is measured on an annual and even quarterly basis, you forfeit the luxury of patience, often having to purchase or sell investments in companies earlier than preferable.

These fund managers also typically have strict investment guidelines forcing minimum investment purchases, even when markets are obviously over-heated and the fund managers would prefer to keep more of their funds as cash.

Is there an answer?

Active fund manager’s costs may be high and their hands might be tied when it comes to purchasing and selling, but you or your adviser’s hands are not. Be patient in your purchases and sales, invest when opportunities present themselves and be prepared to hold investments for the long term. Maintain cash when markets appear overheated and be patient and invest when opportunities prevail and not before.

This is known as ‘dynamic asset allocation’ and something a Financial Advisor can help you achieve. Knowing when an opportunity arises is not straightforward, and you need to be prepared to get the timing and selection wrong sometimes. Organise your investments according to your appetite for risk having an appropriate balance of defensive and growth investments. Your investment portfolio will probably include some actively managed funds, some passive indexed funds, a direct shareholding as well as a balance of cash and property holdings.

For a more detailed discussion of investment theories, email Snowgum Financial Services for a copy of our Investment Philosophy or to talk to me about one of my favourite topics - investing .

By Matt Vickers CFP®

Principal Adviser at Snowgum Financial Services