Episode Details

When I started my career in investment markets almost 20 years ago all the investment options were what we'd now call Active. We didn't call them that at the time, it was just the standard way that money was managed.

Passive investment had been around for some time, pushed primarily by John Boggle of Vanguard which first launched a passive index fund in 1975. But it took quite a while for enough data to come in, for investors to begin to appreciate why some hard questions needed to be asked about the focus on Active investment management.

In more recent times the trend has swung in favour of the passive approach, and variations of that process, with ETF's (Exchange Traded Funds) driving broad adoption.

The increased acceptance and utilisation of passive investment strategies is almost certainly the biggest shift in investment strategy thinking since managed funds kicked off in Australia in 1955.

So in today's episode I'll be sharing with you the difference between these two approaches, and how we apply these alternatives when helping our financial planning clients.

As mentioned, Vanguard is the best known proponent of passive, or index investing, though interestingly Blackrock is bigger.

The idea of passive investment is that instead of trying to do research on different companies and identify winners, you simply buy the whole market. The thinking is that if you do this, you should get the average return of all investors. So let's say you're buying an index fund over the ASX200 – the index of Australia's 200 largest companies. If the ASX200 grew by 5% one year, then that tells you that across all of the investors in that market, half did better and half did worse, and the average came in at 5%.

So if you invest in a passive index fund over the ASX200, you will get the average return, 5% in this example, less whatever fees the fund manager charges.

Now compare this to the Active manager. Their entire rationale is to beat the market. If the average is 5%, their entire rationale for existence is that by doing all sorts of research and analysis, they can identify insights others have missed, and so deliver superior performance compared to the rest of the market.

Now the astute Financial Autonomy audience will immediately identify that given the mathematical foundation of an average is that half of all results will be below, and half will be above, then clearly, not all active fund managers can be successful. Now it is fair to say that not all participants in investment markets are fund managers, there are of course mum and dad investors too, but by far the bulk of trade is conducted by the funds.

And so we arrive at the number one challenge when working with active fund managers – what if you choose one that under-performs?

But in actual fact, it gets even harder, because not only does the successful active fund manager need to beat the index, but they need to do it after their fees, or at least the difference in their fees versus a passive index alternative. And active fund managers tend to like to pay themselves a lot. So beating the average by say half a percent, won't cut it if the fund charges 1% to manage the money in the first place.

So what do the numbers tell us? In data to the end of 2017 (SPIVA Statistics and Reports), when measured over 5 years, only 37% of active funds outperformed the benchmark, and in the US it was even worse with only 16% achieving what they'd set out to do.

To put it another way, if you have some money to invest and you're trying to pick an active fund manager in Australia, there's a 63% likelihood that you'll pick the wrong fund and get under-performance. And in fact that number might be generous due to something called survivorship bias – funds that perform really badly close, and so they don't register in the data.