Active or passive? Why not both?

30 November 2015

 Active or passive? Why not both?

The recent popularity of index funds and ETFs has come with a polarising debate on the merits of passive versus active investing. Lost in this debate is an understanding of how they differ and how each can best serve investors in different segments of the market. Combining the two can give you the best of both worlds. The Bennelong Twenty20 Australian Equities Fund does just this. Julian Beaumont, Investment Director at BAEP, explains.

It’s easy to understand the recent popularity of passive investing. In the constant drive to reduce fees, index funds and ETFs provide just the tonic. Passive funds match the return of the market and charge a fee as low as 0.18%.

Many investors presumably pay higher fees in the belief that active funds will outperform the market. The following chart shows the long-term investment performance of the average core equity fund versus the index.

Not all active funds outperform

While some active fund managers have consistently outperformed – the Bennelong Australian Equities Fund for example has outperformed the market by over 3% per annum after fees since inception1 - the general experience of these funds has been a performance on par with the market itself.

Why do core funds struggle for outperformance?

There are a number of reasons why most core active equity funds have trouble outperforming. A major one results from the heavy concentration of the market in the ‘mega cap’ stocks. The top 20 stocks account for 62% of the total value of the S&P/ASX300 Index2. Large equity funds see the top 20 as an easy opportunity to deploy a similarly large percentage of their funds, and heavily weighting them entails less risk, at least in terms of tracking error. It is not unusual therefore to see these funds made up of at least three of the big four banks (CBA, Westpac, ANZ and/or NAB), a major miner (for example BHP), one of the large retailers (Woolworths or Wesfarmers), and perhaps an insurer (Suncorp or IAG). With so much overlap, it is difficult to differentiate from the index or peers. After all, you can’t do the same thing as everyone else and expect to get a different result.

Getting beyond the either-or debate

While we can understand passive investing’s popularity, we believe the debate on its relative merits is more complex than the either-or approach most often adopted. We believe there is a place in investors’ portfolios for both passive and active investing; it all comes down to when you can, and when you can’t add value from paying for active investing.

Adding value outside the top 20

We believe there is a strong case for paying fees where there are genuine prospects for outperformance. We find this arises once you venture outside of the top 20 stocks into the lesser known parts of the market. BAEP’s Bennelong ex-20 Australian Equities Fund has outperformed its benchmark by over 7% per annum after fees since inception3, and outperformance has been consistent over time.

While there isn’t a comparable fund which has been in the market for long enough to show this as a general proposition for active ex-20 funds, there are a number of good reasons why skilled fund managers can consistently outperform in this space.

The top 20 stocks are well known, heavily researched and are therefore generally priced reasonably efficiently. Some of these companies can have as many as 40 brokerage houses analysing their every move, in addition to the considerable attention they get from professional fund managers, other investors, and the media. In this context, and consistent with the discussion above, the opportunity to outperform is limited. In contrast, some stocks outside the top 20 are covered by just a few brokers, and in some cases there are none at all. These stocks are also relatively unknown to the broader investing public. In this less efficient market in which favourable risk/return opportunities more frequently arise, there is more potential to outperform the market through active management underpinned by extensive analysis and proprietary research.

Combining passive and active to get the best of both worlds

What is often lost in our industry’s drive to reduce fees is an understanding of what one gets in return, and in this respect the investment performance is a far more important part of one’s return. In our opinion, in addition to reducing fees, investors should focus on judiciously leveraging the fees they do pay. Passive investing has its place, and in Australia, that place seems to be in respect of the top 20 where the prospects for outperformance are limited. In our opinion, active fees are better spent where they can earn more ‘bang for their buck’, and that is in the ex-20 market. Combining the two will get the best of both worlds.

Capitalising on this concept, BAEP has recently launched a new product that does just that. The Bennelong Twenty20 Australian Equities Fund invests passively in the top 20 stocks, similar to an index fund, and invests actively in the ex-20 market, along the same tried and tested investment process of the Bennelong ex-20 Australian Equities Fund. The fee is 0.39% (plus a performance fee), which compares favourably with popular index funds and ETFs.


1 As at 30 September 2015
2 Source: IRESS, BAEP, as at 30 September 2015
3 As at 30 September 2015

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