Passive versus active: Which investment style is best?

What is passive investing?

A passive strategy tracks a market index, such as the ASX 200. The investment will mirror the performance of the benchmark it tracks, in this case the top 200 Australian companies listed on the Australian Securities Exchange (ASX).

So, if the ASX 200 Index gains 10% over the year then your ASX 200 Index fund will also return 10% (less fees and taxes). And if the index falls, then your index fund will do the same.

Passive investing tends to be a long-term buy and hold strategy. It is seen as a low-cost way to generate returns because you’re not relying on a portfolio manager to choose stocks, while minimal portfolio turnover translates into low transaction costs. You also retain the rights to any dividends and distributions from the portfolio’s underlying assets.

Exchange-traded funds (ETFs) that replicate an overall market or sector index are becoming very popular passive investment options for SMSFs. There has been an explosion in these products across the asset-class spectrum including shares, bonds, property trusts, commodities and currencies.

Most (but not all) ETFs are passive index funds, while some listed or unlisted managed funds are also passive index funds. You can buy unlisted funds directly from fund managers and listed funds on the ASX and other markets. 

In fact, some fund managers offer the same or similar underlying investments in different structures – as a traditional managed fund, an ETF and/or a listed investment company or trust (LIC or LIT).

Discover the most popular ETFs with SMSF investors, the most popular LICs/LITs and the most popular managed funds.

What is active investing?

In an actively managed fund, a professional portfolio manager makes decisions about how to invest the fund’s money. The goal is to outperform the market and index, buying and selling underlying investments based on short-term performance.

Actively managed investment funds, both listed and unlisted, and LICs and LITs that trade on the ASX are among the active options for SMSF investors. Some ETFs are also actively managed, so it’s important to understand each fund’s underlying investments and investment strategy. 

Active investment managers look for ways to maximise profits using various strategies. For instance, they may target undervalued companies or those with potential for higher growth than their peers. They may also use derivatives to manage risk, or gearing (borrowings) to boost potential profits (and the risk of bigger potential losses).

Active versus passive performance

As active managers aim to outperform their chosen benchmark index, intuitively it makes sense that active funds outperform index funds. But that’s not necessarily the case.

For the past 20 years, S&P Dow Jones (which produces the widely used S&P indices) has compared the performance of active and passive funds in its SPIVA Scorecard.  

As you can see in the table below, its most recent annual scorecard found the majority of actively managed funds underperformed their respective benchmark index over most time frames.

Table: Percentage of underperforming active Australian funds (for periods ending 30 June 2023)

Sources: S&P Dow Jones Indices, Morningstar. Data for periods ending 30 June 2023. Index performance based on total return. Past performance is no guarantee of future results.

The underperformance was most marked for actively managed international share funds, with the percentage of funds failing to meet or exceed their benchmark index ranging from 76% over one year to 95% over 15 years.

The only asset class where the majority of active managers outperformed their benchmark was Australian bonds and even then, only over shorter time frames.

Pros and cons of a passive approach

As passive funds don’t aim to time the market or pick individual other investments, they have some key advantages and disadvantages when compared with active funds.

Pros:

• Lower fees. Average management fees for passive ETFs are about 0.25% compared to around 1% for listed managed funds (most are actively managed) and 1–1.5% plus performance fees for LICs/LITs. The lowest cost ETFs charge less than 0.1%.
• Greater transparency (index fund providers publish all the fund’s underlying investments daily).

Cons:

• No prospect of beating the market. If the index you’re tracking falls, so does the value of your investment.
• Some strategies may not be available. While the range of ETFs and other passive funds is expanding all the time, some sophisticated strategies may not be available.

Pros and cons of an active approach

While timing the market and picking winners is notoriously difficult, even for professionals, some active funds do deliver.

Pros:

• Flexibility. The ability to cherry pick potential winning investments, even when the overall market is falling, and avoid losers that might drag down the performance of an index.
• Access to a broader range of strategies. Active fund managers may engage in activities such as short-selling or use derivatives and other financial instruments to protect against losses and potentially boost returns.

Cons:

• Higher cost due to active trading and associated transaction costs, performance fees and use of derivates and other financial instruments. As outlined earlier, average management fees for listed managed funds are around 1% and for LICs/LITs 1–1.5% plus performance fees, compared with 0.25% on average for passive ETFs.
• No guarantee of higher returns. As the table above shows, only a minority of active fund managers consistently beat their benchmark.

Be aware that active managers who consistently beat the market are few and far between and their wins in the short term may be due more to luck than skill. Always remember past performance is never an indication of future performance.

The bottom line

Trying to time the market by moving in and out of assets can do more harm than good. You’re often better off hanging in there and focusing on your long-term goals, especially when you’re investing your super savings for your retirement.

Whichever your approach, the best option is to ensure the way you invest is aligned to your investment goals, risk tolerance and personal preferences to achieve the best return over the long term