Active versus passive: does it have to be a choice?

As there is a large degree of replication amongst large equity funds, and similarity in performance, there is a case to use both active and passive strategies, Julian Beaumont writes.

Debating the merits of active versus passive investing seems to be a favourite past-time for many, but the reality is that each offers different advantages for investors.

And combining the two means investors can have the best of both worlds.

Passive investment, which simply aims to give investors the return of that particular asset class by tracking the market index, certainly has its place.

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Investors might not beat the market, but they will not underperform it either.

Passive investing has been particularly popular in recent times, especially with the constant drive to reduce fees. Passive funds match the return of the market and tend to charge lower fees.

Active investment, where an investment manager backs its research and investment skill to generate a return above the market return — known as alpha — also has its place.

Investors pay higher fees in the belief that the research and knowledge of the investment manager will deliver outperformance.

Certainly some active funds have regularly outperformed, but others have struggled.

One of the problems facing active managers is that the Australian share market is very concentrated. The top 20 stocks account for about 58 per cent of the total value of the benchmark S&P/ASX 300 Index.

As a consequence, these stocks account for the majority of the performance of the index — whether positive or negative.

To avoid the risk of significant underperformance, large equity funds tend to have big holdings in the large caps that closely mirror the index's allocation to those stocks.

Therefore, most funds hold at least three of the big four banks, a major miner (either BHP or Rio Tinto), one of the large retailers (either Woolworths or Wesfarmers), and possibly an insurer (either Suncorp or IAG).

The result is that there is a large degree of replication amongst large equity funds, and similarity in their performance.

It also limits the ability of active fund managers to add value. In our view, it is almost impossible for any manager to deliver outperformance from the top 20 stocks, which are so heavily researched, monitored and analysed that there is relatively little opportunity for managers to acquire, and leverage, insight.

A company like BHP is covered by almost 40 brokerage houses across London and Australia, not to mention the considerable attention it gets from professional fund managers, investors and the media. In this context, the opportunity to outperform is limited.

But it is a different story outside the top 20. Companies are much less researched and, in some instances, not covered by any analysts at all. These stocks are also relatively unknown to the broader public.

This means the market is much less efficient, and provides opportunities for fund managers to generate outperformance.

While we can understand passive investing's popularity, the debate on its relative merits is more complex than the either/or approach.

What is often lost in the drive to reduce fees is an understanding of what one gets in return, and in this respect the investment performance is a far more important part of one's returns.

There is a place in investors' portfolios for both passive and active investing; it all comes down to when you can and can't add value from paying for active investing.

There is a strong case for paying fees where there are genuine prospects for outperformance. We find this arises once you venture outside the top 20 stocks into the lesser known parts of the market.

The solution, when you think about it, is obvious. Combining the two can deliver the best of both worlds.

Use passive investing for the top 20 stocks — holding the index weighting for those companies — and use active management for the remainder of the investment universe.

The benefits for investors of this kind of approach include:

• Low cost — investors are not paying an active management fee for a passive investment in the top 20 stocks;
• Low tracking error;
• Intelligent exposure to the entire investment universe of the ASX 300; and
• Opportunity for outperformance where it is most commonly available — outside the top 20.

By investing across the S&P/ASX 300 universe — through a combination of actively managed ex-20 stocks, as well as a passive exposure to the top 20 stocks — investors are getting the best of both words, and gaining exposure to the entire spectrum of the market.

Julian Beaumont is the investment director at Bennelong Australian Equity Partners, a boutique partner of Bennelong Funds Management.