Index or active? Four rules for making a call

Investors need to weigh many competing considerations on the path to achieving their investment goals—whether it’s saving for retirement, buying a new house or educating their children.

A good starting point is selecting the asset class exposure that fits their risk profile and investment objective—from shares to bonds and everything in between.

Then they need to determine the preferred vehicle to deliver on their investment goal, whether an index fund tracking broad market performance, an actively managed strategy that holds a selective slice of the market, or a mix of the two.

It may be that active management improves the chance of meeting their investment goals, whether it’s outperforming a benchmark, maximising yield or dampening portfolio volatility, or it may be that index management is better suited.

The big question then is how to achieve the Goldilocks scenario of getting the mix of index and active just right.

Not too hot, not too cold

Investing is a zero sum game, in which each fund that outperforms the market does so at the expense of others, which underperform average market returns. While index managers should deliver close to the market return after costs, active managers will either beat or be beaten by their benchmark.

According to S&P’s scorecard of active manager performance for 2016, 74 per cent of Australian domiciled broad-cap active equity funds underperformed over 10 years, after costs. So as the odds of making a successful choice of active manager can be low, it’s important to put rigorous standards in place when deciding how much active and index exposure is appropriate.

A framework that helps set the proportions of active and index exposure can help investors make a disciplined call to give themselves the best chance of success.

1. Gross alpha expectation. What level of outperformance do you expect and what’s your conviction in the investment manager’s ability to deliver it? Higher conviction would warrant a higher allocation to active, while lower conviction would indicate a higher allocation to an index strategy. It’s worth looking at the active manager’s investment principles, security selection process, firm ownership structure and the experience and tenure of their team.

2. Cost of active. How much are you paying to invest? If you don’t have the means to access active management at a low cost compared to your expected outperformance, then a lower level of active may be appropriate. Lower fees mean an investor keeps more of their returns, increasing their odds of achieving outperformance.

3. Active risk. How much active risk is your investment manager taking, measured by the expected difference in returns both above and below the benchmark? A greater level of active risk may be tempered by using a higher level of indexing.

4. Risk tolerance. What’s your tolerance for taking active risk? If you can tolerate a high degree of underperformance without losing your nerve, then a higher weight to active may be for you.

This decision-making framework can help investors work out whether an active or index strategy is right for their circumstances.

But patience is the key. For those Australian managed funds that outperformed over the past 15 years, 97 per cent still experienced three or more individual years of underperformance, with 60 per cent experiencing six or more1.

A framework like this might not always deliver investors the ‘just right’ Goldilocks combination of index and active, but it can help keep their investment goals at the forefront of their decision-making, ensuring that they choose the right funds or investment strategies for the right reasons.

For a deeper look into the framework for making the active-passive decision, click here

* A longer version of this article first appeared in the Australian Financial Review on 26 July 2017.




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