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.

Investment Mix

Bonds, property, cash or shares? Choosing an investment mix

A little knowledge can go a long way when determining which investments are appropriate for your tolerance to risk, investment goals, timeframe and circumstances. It is therefore important to have some idea of how your ‘investment mix’ is created and where your money is going.

The most common asset classes represent different types of investment – cash, shares, fixed interest and property. Each asset class has a different level of risk and return, and therefore perform differently over time.

Risk and return
When you choose an asset class for your investment, it’s important to understand how it works, and to be clear about investment timeframes so you’re not setting yourself false expectations of how your money should be tracking over time.

When focussing on structuring your investment portfolio, remember investments that have provided higher returns over the longer term may produce a wider range of returns over the short term. This may mean these investments may not help you to meet your short term investment goals.

Let’s look at the different types of asset classes and the risk level involved.

1. Cash and fixed interest

In a nutshell: defensive assets, such as cash or fixed interest, are generally aimed at providing stable, more consistent returns.

  • Cash
    Cash refers to bank bills or other similar securities, which generally have a short term investment timeframe and provide more stable returns and a narrower range of returns over the shorter term than some other investments such as shares.

Risk level: Low risk

Minimum suggested timeframe: No minimum

  • Fixed interest
    These are securities such as government and corporate bonds and generally operate in a similar fashion to loans. You can get a regular interest payment from a bond for an agreed period of time and the value can go up and down, depending on changing interest rate levels. You get your initial outlay of cash back when the bond matures. Bonds have historically offered returns that are generally more consistent, but lower, than shares. They still contain some level of risk higher than a cash investment.

Risk level: Low–medium risk

Timeframe: Minimum suggested 3 years

  1. Property securities, Australian and international shares

In a nutshell: growth assets focused on capital growth and income.

  • Property
    Property can be bought directly or you can buy it indirectly via property securities. Property securities are usually listed on a stock exchange and traded in a similar way to shares. Depending on the specific security, each property security can represent an investment in a real property in various sectors including retail, industrial and office.

Risk level: Medium–high risk

Timeframe: Minimum suggested 5 years

  • Shares
    You can buy shares in companies locally and/or internationally. Your money buys you a stake in the company that can be traded on a stock exchange. This can be done directly, or through a managed fund, which will pool your money with other investors to buy shares in various companies.

The value of shares tends to fluctuate and shares are considered to be more risky than other asset classes. However, over the longer term, shares have historically tended to outperform other asset classes.

Risk level: High risk

Timeframe: Minimum suggested investment 7 years for both Australian and international shares.

What To Do With A Windfall

Four tips on what to do with a windfall

If you were lucky enough to land a windfall, before you rush off on that long dreamed of holiday, here are four practical considerations:

  1. Reduce your debt

The most financially sensible thing you could do, is pay off debt. Before doing anything else with you cash, it would be wise to pay off loans which charge you the highest rates of interest, such as credit cards, car or personal loans, store cards or short term loans.

Only then should you consider paying off your mortgage, in full or in part, because your mortgage is likely to be charging you the lowest interest rates. Apart from the savings you’ll make from lower interest payments, getting rid of debt could also eliminate financial stress and allow you to focus on smarter financial decisions for your future.

You should speak with a financial adviser about your current situation. It doesn’t matter what stage of life you’re at, how much money you have, or how much advice you need

  1. Plan for retirement and build up your super balance

You should consider taking advantage of non-concessional contributions and build more of your wealth within super, rather than having it all invested in your own name in the bank. Non-concessional contributions refer to after-tax amounts which are indexed each year.

Under current rules, you could contribute $180,000 in non-concessional contributions. Further, and subject to regulatory compliance, if you are 64 years old or less anytime in the financial year and you make a non-concessional contribution, it would trigger a ‘bring-forward’ provision, and you could contribute up to $540,000. This would result in a significant tax saving on your investment earnings, but it would depend on your personal income levels. Keep in mind, though, that the downside of building up your super is that you cannot access the money until you stop working or retire (subject to meeting a condition of release).

  1. Diversify your investments

Keeping large sums of money in the bank at current term deposit interest rates may not be the best investment in the long term. You could work out what large capital expenses you may have over the next three years and leave this sum in the bank, but the remainder could be invested in a more growth-oriented manner, depending on your appetite for risk.

If you have already purchased an investment property, you could consider building up investments in Australian shares, international shares and other asset classes to diversify your investment portfolio.

You could also look at a managed fund that is appropriately diversified across a number of asset classes, but a good portion could be in Australian shares which aim to deliver the growth that can be achieved over the long term with this asset class.

  1. Find a financial adviser

You should speak with a financial adviser about your current situation. It doesn’t matter what stage of life you’re at, how much money you have, or how much advice you need, it could be beneficial for you to sit down with a financial adviser and work out your short and long term financial goals and aspirations. For more on how you could benefit from financial advice, see The right advice can make all the difference.

Mortgage Paid?

Mortgage paid? Save for the future

Now that you’ve paid your mortgage off, here are three ways to start thinking about building wealth for tomorrow: 

  1. Invest regularly in managed funds

Paying off a mortgage teaches you the healthy financial habit of saving a certain amount of your pay check each month. Why not keep up that discipline with a regular investment into a managed fund?

Managed funds can help you gain exposure to a diverse range of assets, even for a relatively small investment. You’ll also get the benefit of the expertise of the fund manager who selects and manages the investments — so there’s no need to research and choose stocks yourself.

By regularly investing the same amount of money over time, you’ll be employing a strategy known as ’dollar cost averaging’. Dollar cost averaging is an investment technique where money is invested at regular intervals, rather than in a single transaction. By investing on a regular basis, you don’t need to rely on ‘timing strategies’ which aim to pick when a market has peaked or reached the bottom of a cycle.

You make regular contributions regardless of what the market is doing, which means sometimes you pay more, sometimes less for your investments. The differences in price even out over time.

Dollar cost averaging imposes investment discipline. It is useful to slowly build exposure to markets and smooth out the risks associated with market fluctuations.

It’s like buying $100 worth of apples every week — you get more when they’re cheap, so you end up with more cheap apples than expensive ones. Then, if apples go up in price, you’re investment should be worth more than you paid for it. However, the cost of apples will go up and down.

  1. Salary sacrifice into super 

Another good place to invest some of your income is into your super, through a salary sacrifice arrangement.

It’s easy to do — simply arrange for your employer (if this option is available) to pay part of your pre-tax salary into your super, along with the compulsory superannuation guarantee super payments they already make. There are limits to the amount you can contribute so ensure you seek financial advice.

Salary sacrifice may also be a very tax-effective strategy. That’s because it comes out of your pre-tax earnings, which means it may lower your assessable income. As a result, you could pay less income tax each year, while building your retirement savings.

What’s more, the money you salary sacrifice to your fund is taxed at just 15% within super. So if you’re in a higher tax bracket — for example, if you’re paying a marginal rate of 46.5% tax — this could reduce the tax you pay on this money by 31.5%.

  1. Diversify into other types of investment

Many Australians like to put money into investment properties. And there’s no question that this could be a great investment, with potential capital growth and rental income. But don’t forget the importance of diversification, spreading your investments across a range of assets, markets and industries — including overseas.

For example, international shares can give you exposure to rapidly growing emerging markets, such as China, Russia and India. You can also enjoy access to the developed markets, and some of the world’s most successful companies.

You may also want to consider investing in fixed interest assets, like term deposits or bonds, for more predictable returns.

Or if you are keen to stay in property, indirect investment property is another option. By pooling your money with other investors into a property fund, you can gain exposure to commercial or overseas property, at a lower cost than investing directly.

If that all sounds too hard, there are plenty of managed funds to choose from, that can provide instant diversification — without having to do the legwork yourself.

Making your money work for you

Investing can be complex, and everyone’s financial situation is different. So it’s important to get the right financial advice. A financial adviser can work with you to determine the most tax-effective investment to make the most of your surplus cash.

Get The Right Advice

It’s never too late to get the right advice

Receiving financial advice from an expert could change your life and give you the peace of mind only a well-constructed plan can bring. A financial adviser may assist in maximising your retirement income and plan a better retirement lifestyle for you.

Australians are living longer than ever. A man finishing work at 65 in 2011-2013 could expect to be retired for more than 19 years, rising to 22 years for women[1]. It’s important to have enough saved up to last the distance.  Yet quite often not until our 50s or later that we start seriously saving for retirement.

It is never too late to improve your financial situation and make much better use of what you already have.

With advice, you can find out about strategies that you can put in place in the final years before retirement. So your financial situation can improve.

Planning ahead

The ideal situation is where your wealth continues to grow in retirement, but not all of us can be in that situation. This is where a financial adviser comes in.

One of the most important things a financial adviser can do is to help you understand how much income you’ll need in retirement and the total amount to provide for that income.

While people retire from paid employment, they don’t retire from life.  And a longer healthier life means people will be doing more things and thus need greater financial resources.

Maximising retirement savings

Investors in their 50s and 60s have a number of ways to build their retirement wealth but super in a high tax country like Australia, is often the most tax effective way.

By using a transition to retirement strategy, where salary sacrificing of before-tax income into the super account and then using income from the super pension to live on, investors can reduce the tax they pay and direct more money back to their super fund.

Recovering from the GFC

It is often that the lead up to retirement is an important and most crucial time to see a financial adviser— especially in the wake of the GFC.

Advice after retirement

With 20 years or more in retirement, getting ready to leave the workforce is only the first step it is also essential to receive ongoing advice after you’ve left work for good.

Constant changes to super rules can also be dangerously confusing without the right advice.
The ongoing changes and regulatory proposals may have a significant impact on your wealth and thus it is even more crucial to consider meeting a financial adviser.

[1] http://www.aihw.gov.au/deaths/life-expectancy/