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Quality Investments in Troubled Times – Active vs Passive Investment Strategies

This blog post looks at the historical performance of the two main Australian Share managed funds that are within our model portfolio from August 2007 to August 2012 which covers the brutal 5 years of the Global Financial Crisis (GFC). We also discuss the type of investment managers we use and the impact that this has on returns in different time periods. 

Within the investment community there has, and will always be, a debate about whether it is best to invest in the share market using an active or a passive approach. It is like Ford vs Holden, automatic vs manual, Apple vs Microsoft or PLC vs DCS for control of a processing plant.

As with all these debates, there are compelling reasons for each option…except perhaps in the case of Fords.

The statistical analysis, as always, depends on the time frame over which you review.

Part of the reason for variation in investment return figures that occurs over different time periods can be explained as follows:

1.Active managers can under-perform the index in stronger return periods i.e. pre GFC.

Why? Poorer quality companies who during periods of economic weakness may have large losses, can often turn profitable when strong economic growth returns and therefore can have an upswing in share price. This upswing can be greater than the rise of quality companies in the same time period. So where active managers refuse to invest in poor quality companies their investment performance can have periods where it doesn’t keep pace with the broader market returns (or the index).

2.Active managers can out-perform in periods of weak market returns

The type of active managers we use are not selected to outperform the market in years of strong share market performance. They are there to avoid the poor quality companies and select the good quality companies that can be purchased for a reasonable price.

So if you look at an index approach vs our active managers, our active managers outperform in steady or weak economic periods and may under-perform (however still making good investment returns) in the periods of exuberant growth.

Our Approach

Our two main Australian share managers’ performance tables ending 31st of August are shown below and this highlights our out-performance after fund manager fees during the GFC period. These funds represent a large portion of our model portfolio for clients.

 

Fund 1 month 3 month 6 month 12 month 3 years 5 years Source
Australian Share Fund #1 3.07% 8.71% 9.09% 15.72% 7.89% 0.86% Fund manager website
Australian Share Fund #2 3.64% 8.11% 3.72% 9.24% 6.27% 1.23% Fund manager website
S&P/ASX 300

Accumulation Index

2.10% 7.00% 2.30% 4.98% 3.03% -2.98% Note the lower Index returns compared to all time periods

Note: Performance figures are PA figures where the period is greater than one year.

What is often missed in this debate is whether or not out-performance is a practical necessity for most families or if the associated swings in valuations and returns that accompanies chasing out-performance can be destabilising to a family’s lifetime investment history. We take this into consideration.
Some of the factors we also consider in addition to the statistics based debate about passive verses active investing include the following:

  • The source of the funds being invested. If it is borrowed money then we believe it is prudent to achieve nice returns whilst minimising the downside risk by using the right active managers rather than chase that extra 1 or 2 per cent annual growth. In fact, we are happy to under-perform the market some years knowing we have a much lower risk of losing money.
  • The attitude and experience of the investor. Often individuals haven’t had a lot of investment experience but it is important they gain that experience and remain confident to invest throughout their life. Remaining confident to invest throughout life is crucial to help most to achieve financial freedom. So if a more positive experience can be gained by using the right active managers who reduce a lot of the risk of investing, it can far outweigh the benefit of chasing the higher returns.
  • The type of active managers we use aim to provide good returns without the normal level of risk and an outcome of that process is often a portfolio that pays a higher level of dividends and a higher level of franking credits than the overall share market. This higher income level is quite stable compared to the capital growth so is also a welcome part of the return from investing.
  • Whilst there is a tax driven argument that says capital growth is more desirable than income for high tax payers it is important to realise that it becomes harder to achieve a return of 10% pure capital growth than to achieve a similar result after tax return using a mix of income from quality companies and some capital growth.

So even before the crystal ball is pulled out to decide whether an active or passive management strategy will be best over the next period of time, the desirability of the risk reduction provided by the right active managers, the lower fluctuations in value through the economic cycles and the higher income paid are generally the prevailing factors in our clients’ final decisions.

If you would like to discuss options or you are interested in a more in-depth discussion of the pros and cons of active vs. passive investment options please contact us. We can also send you an article from our preferred research house called Lonsec with more information.

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