Q. I am considering investing into shares either through Managed Funds or Exchange Traded Funds.  Can you please explain the difference between active portfolio management and passive portfolio management?  There appears to be a huge difference in costs for each approach to investing into these funds.

A.  Active portfolio management focuses on outperforming the market compared to a specific benchmark that relates to the assets in the portfolio.  Investors who apply an active portfolio management approach use fund managers or brokers to buy and sell stocks in an attempt to outperform a specific index.  For example, an Australian Share Managed Fund may be benchmarked against the All Ordinaries Index or the ASX 300 index.

Unlike active management, passive portfolio managers select stocks and other securities listed on an index and apply the same weighting to the portfolio as applies to the index. The purpose of passive portfolio management is to generate a return that is the same as the chosen index instead of outperforming it. Because this investment strategy is not proactive, the management fees assessed on passive strategies are often far lower than active portfolio management strategies.

Portfolio managers engaged in active management focus on factors that may impact the performance of specific companies within their portfolio. The primary objective being, to take advantage of irregularities and miss-pricing.   Active managers promote their funds to the market on basis of their ability to generate greater returns than those achieved by simply replicating a particular index.

At various times in the market cycle, active and passive management approaches will perform better.  Investors will tend to invest into active management if there is evidence that the manage is outperforming the market nett of fees.  Likewise, if the market is generally rising and active managers are struggling to outperform the market, it becomes challenging for the active manager to make the case for outperformance net of fees.

Since 2008, US Managed Fund investors have withdrawn more than US$800 billion from actively managed funds.  In the same time period, they have invested a staggering US$1.8 trillion into index funds.  The pace of change has accelerated to the point that in the first quarter of 2017 in the US, for every one dollar invested in active funds, nearly $5 was invested into passive funds.

The consequences for markets are profound.  Where the market valuation of a company is determined more by capitalisation of the stock and its index weighting, than the underlying fundamentals of the company, enormous opportunities for mispricing of stocks can occur. This stock mispricing may be masked by the volume of passive money entering the market.

In a rising market, active managers may “swim against the tide” of passive fund inflows by making calls on shares that may be large in index weighting but the Fund Manager may feel are overpriced.  When passive money continues to dominate new investment into the market, these stocks will continue to have price support that may not be warranted.

When money leaves the market and prices fall, passive investors with an index weighting bear the brunt of market exposure.  During a bear market, active managers typically can demonstrate the value of their investment thesis.

Generally speaking, in a falling market, active managers who invest in shares on the basis of a company’s fundamental qualities are more likely to outperform the broader market albeit at a higher management cost.

Passive Portfolio Management provides low-cost exposure to a particular market.  However, the approach does come with inherent market risks that need to be considered as part of any long-term strategy.  Pricing of this risk is critical in constructing a portfolio regardless of how cheap passive management or expensive active management may appear at any given stage of the investment cycle.