International Investing: Active Vs Passive investments – Gain from global experience

Published: June 30, 2020 11:01 AM

Unlike in India where you have a handful of options for passive funds, globally – there are scores of funds with varied themes for which an index or an ETF or a passive fund may be existing.

 International Investing, Active Vs Passive investments, global index funds, etf, fund managers, assetsMost global investors prefer to have a higher allocation to passive funds rather than to funds that are actively managed.

By Apoorva H Vora

The last decade has seen a little over 4-fold increase in the size of global index funds (including ETFs). Passive investing took a long time for it to become acceptable, ever since its start in the ’70s. However, the stellar growth of the last decade has transformed the business of managing assets.

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Globally, we have witnessed a shift from active to a passive style of management in a big way. According to one recent study by Morgan Stanley, it is estimated that only the top decile of performing fund managers were able to retain their assets.

Though in the early stage, we are witnessing the surge of passive investing style catch-up in India too. What started as a mere replication of key indices, has given way to the development of a variety of options within passive investing, including bonds.

Active Investing vs Passive Investing – simplified

Active investing is a style where the manager attempts to beat the performance of the benchmark by actively selecting securities that are likely to outperform and ignore the securities that are likely to be underperforming. With a change in dynamics of the underlying, the manager keeps changing the allocation. This includes even the management of portfolio weights for each of the underlying.

Passive investing on the other side is either to invest in an ETF, or investing in an Index Fund (where the manager replicates index weights or may also have a passive strategy) which does not require any major role in the selection of the underlying security. Needless to mention, such funds involve lesser costs and therefore in matured markets, they tend to perform better at least on an average.

The global experiences

If one looks at long-term records of managers in evolved global markets, there are very few active managers who have been able to outperform the benchmark returns. Even after a lot of research, higher costs and relative difficulties of fund selection, active managers are unable to outperform the benchmarks. In such a scenario, it is obvious that most global investors prefer to have higher allocation to passive funds rather than to funds that are actively managed.

Another important factor for an investor is the choice available for selecting a passive fund. Unlike in India where you have a handful of options for passive funds, globally – there are scores of funds with varied themes for which an index or an ETF or a passive fund may be existing. An investor can play various themes and create a portfolio that suits the overall investment objective. It is, therefore, a lot easier for an advisor as well as an investor to select a few themes.

Cost, obviously, remains an important factor to consider. When the universe of passive funds is performing better, and with lesser costs, it is natural for an investor to have a higher allocation to passive managers. In a competitive landscape of fund management, many funds have been able to demonstrate their value by lower management cost.

Manager continuity is another factor while assessing the fund selection. This is critical for active management style. However, passive style of investing is relying a lot more on the process of the underlying index and, therefore, is immune to fund manager continuity.

Is the role of active management diminishing?

Going by the industry data of last decade, passive investing has grown exponentially within global markets.

When an investor is considering global allocation, it is very difficult to take an individual bet on a stock or even a sectoral theme. While selecting an underlying investment from global markets, an investor or an advisor prefers the passive investing option largely due to (a) the superior performance of passive style of investments; (b) ease of tracking an index or an ETF globally rather than tracking the individual security; (c) lower costs, also given the fact that an additional feeder fund or an overlaying platform would have additional costs; and (d) ease of alignment with portfolio.

Active management also has a space in portfolios, but that requires a slightly higher degree of understanding and is dependent on the flexibility of the platform. Not all investors prefer to invest via a feeder fund route when investing globally. There are a few very friendly platforms that help an investor/advisor create a portfolio mix which can then be managed dynamically.

While the underlying could be a passive fund, the management of the platform can be active. Here an investor can change the allocation from one country to another, one asset class to another, one fund house to another, besides inter-fund switches. This helps an investor align the investment completely to the combination of strategic as well as tactical asset allocation.

To summarize

While the passive style of investing is gaining acceptance and popularity among investors, particularly when investing globally – a hybrid mode of active management of passive funds is also gaining acceptance, especially for investors committing money globally for a longer time horizon.

(The author is Founder and CEO, Finolutions Wealthcare LLP.)

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