Passive Vs Active Investing

Thoughtful people who are long-term investors must first decide on their investment objectives when deciding between active or passive managed funds.

Investing in equities is an increasingly popular method of assisting people to achieve their long-term financial goals. An investment in equities can generate promising returns over time as companies grow and become more profitable.

Further, dividends paid by listed companies also provide a good income stream for investors. In Australia the benefit of franking credits enhance the attractiveness of equities as an asset class.

However, there are also risks associated with investing in shares. Companies that struggle are likely to see their share prices fall and stock markets as a whole can be affected by periods of economic weakness or unexpected events, as illustrated by the chart on the next page.

In order to minimise risk many investors maintain exposure to shares in professionally managed funds. These funds are usually well diversified, spreading investment risk across a wide range of companies. There are two distinct types of funds that are available to investors – active funds and passive funds. In this paper, we will take a closer look at both types of funds and highlight the key differences between the two.

 What is active investing?

Most actively managed funds aim to outperform a particular index, for example the S&P/ASX 300 Accumulation Index (ASX 300).

To achieve this, the fund managers actively research companies that are constituents of the index. Professional managers typically have the resources required to complete detailed analysis on companies and skilled investors can identify those likely to perform better than the market average over time. These qualified investors have access to information, research and robust investment processes that are not readily available to individuals.

Following this analysis, active fund managers buy and sell shares in an effort to maximise returns for investors. They will buy stocks that are expected to perform better than the broader market, sell winning stocks following a period of favourable performance, and avoid those that are expected to underperform.

The intention is that the combined portfolio of shares will perform better than a comparable index, normally referred to as the ‘benchmark’. Of course there is also a risk that active funds will perform less well than the benchmark index if the selected stocks do not perform as well as the manager anticipates.

The performance of active managers is typically measured against these benchmark indices, which they try to outperform by a given margin. The extent to which returns vary from those of the benchmark index is a fair indication of the manager’s skill.

Chart 1: Volatility in sharemarkets is constant

Graph 1

Source: Colonial First State. S&P/ASX 300 Accumulation Index Jan 1995 – May 2014. Chart is for illustrative purposes only.

What is passive investing?

A passive investment manager tries to replicate a sharemarket index, such as the ASX 300, by owning shares in each constituent of the index. The quantity of each stock held is determined by the stock’s weight in the index. If BHP Billiton accounts for 8.6% of the ASX 300, for example, a passive fund manager will invest 8.6% of the fund’s assets in that stock, and so on, for every stock in the index. The investor should expect returns to be close to that of the market index.

 Which type of fund is right for you?

In deciding on the style of investment, investors must first decide on their investment objectives, in particular return targets. Most investors would expect to generate returns that are above that of a market index and would prefer investing in an actively managed fund. In this case, the selection of the active manager is crucially important and the consideration for investors is their confidence in an active manager to achieve their investment objectives. While past performance is not necessarily an indication of future performance, most investors will consider a manager’s long-term performance track record before making an investment.

Cost is another differentiator of the two styles. Actively managed funds typically charge a higher management fee to cover research costs and to pay for the large teams of experienced analysts that are typically employed in the management of the fund. In contrast, because no attempt is made to outperform a benchmark index through research or stock selection, management fees for passive funds tend to be much lower than for actively managed funds. Cost should not be the main factor in picking a fund as contrary to the belief of many investors, selecting an active fund based solely on a low fee can be a mistake.

Here is a summary of some of the key advantages and disadvantages of active and passive funds:


Management style Advantages Disadvantages
Active ·       Opportunity for the fund manager to research and select stocks that are expected to outperform the market average over time

·       Potential to outperform a benchmark index and maximise returns for investors

·       Potential to underperform the benchmark if the selected stocks do not perform as well as expected

·       Higher fees

Passive ·       Very low risk of the fund underperforming a benchmark index by more than cost of fees

·       Lower fees

·       No opportunity for fund managers to actively select stocks that are expected to outperform

·       Typically unable to outperform a benchmark index


One approach is not necessarily better than the other. Before making an investment, it’s always best to speak to a financial adviser, who can help you select a fund – whether active or passive – that can help you achieve your investment goals.

Ethical Investing

Ethical investing involves much more than most people realize.  It can offer numerous opportunities and benefits for individual investors and those preparing for retirement.

So then, what does it mean to invest ethically?

The basics investment process

In order to truly understand your equity portfolio and make the correct selections, it’s important to comprehend the drivers behind the businesses you’re investing in.

Who is on the management team and what is their track record, for example? What types of products or services does the business offer and what is their target market? Which raw materials or talent sets do they require in order to succeed, and how do they go about sourcing these? How sustainable is the company and how does it treat its people and its local communities?

Ethical Investment plan

These are the same questions that should be asked when an investor is putting together an ethical investment plan. Investing ethically, in a nutshell, is all about understanding exactly what it is that your money is funding, then ensuring the funded businesses will not have a negative impact on society and on the environment.

 Differentiating between ethical and other investments

There is no absolute rule as to what is and is not an ethical investment. It very much depends on individual beliefs – which could be to do with religious belief, political leanings, environmental concerns or any one of many other variables – as well as the effects of location and time. A person living in a small town that is receiving much-needed mining income, for example, will have a different opinion to the city-dwelling environmentalist. During a time of war or civil unrest, people in certain territories around the globe will think differently about businesses involved in weapons manufacture. And while some feel uneasy about companies involved in alcohol marketing and production, others admire the quality of their brands and products and their promotion of responsible drinking.

In other words, ethical investment allows individuals to put their money behind businesses that match their own belief systems. It doesn’t necessarily mean the chosen organisations will outperform ones that are considered non-ethical. But it does mean greater satisfaction with, and likely more personal interest in, the set of businesses within the portfolio.

 Balancing investment performance with social responsibility

In order to balance social responsibility with investment returns, an investor must look into the business’s sustainability and HR record. They must get to know the products and services and find out what the business does to make these offerings a reality. In other words, they must develop a far more intimate understanding of the organisation than they would if they simply purchased shares thanks to a company’s growth record. Such a thorough investigation is a powerful exercise and one that is likely to pay dividends, in more ways than one, during the lifetime of the investment.

Speaking to fund managers

An investor may also choose to look into various funds that make it their business to buy shares only in ethical organisations, although you’ll want to check carefully to make sure your philosophies match up. Such funds may have investment policies that involve strict and pure approaches to ethical investing, while other may simply have loose guidelines that exclude certain types of organisations.

If the many positives of ethical investing are of interest, bring up the topic during your next meeting with your financial planner. They can help you to understand your current levels of ethically correct investment exposure and recommend strategies and choices for those that would like a greater comprehension of what exactly their money is supporting.