Partner Series

Active investing with passive funds

The debate between active and passive investing has always been contentious but has taken an interesting twist in recent times. Some investors have sought a ‘best of both worlds’ approach by using passive investments in an active way. So, what does it mean to invest in this way, and does it work?

Kanish Chugh, co-Head of Sales at ETF Securities, spoke to Nazar Pochynok, Financial Adviser at Bell Partner Creations and Andrew Wielandt, Managing Partner for Dornbusch Wealth, on Active investing with passive funds.

Taking an active approach

Normally when investors think of passive or active, they think of very specific investment products. Passive investments are defined as those which follow rules or a methodology to automatically follow an index or benchmark with the aim to “match the market”, while active investments are discretionary, meaning they are made based on a fund manager’s research and philosophy.

“The way we use active management is a little bit different. We use it from a risk management perspective of looking at how to change the dynamic asset allocation of our passive portfolios,” says Mr Pochynok.

He primarily uses passive investments like ETFs in his portfolio to offer cost-effective access to particular assets and markets.

Mr Pochynok says, “nothing in passive is truly passive. Everything is an active decision. For example, the underlying constituents of companies and the relative benchmarks they track from ETF to ETF really does differ. Do you choose an index that is cap-weighted or equal-weighted? Should the index have style factors incorporated, such as quality, size, momentum and volatility? All these decisions are not submissive. And they're very much active manager thinking more so in a cost-effective and simple-to-use strategy.”

Is passive really passive?

Passive investing has become increasingly popular in recent years as it offers liquid cost-effective exposure across the market or to specific assets, sectors or themes which may otherwise be difficult to access. Despite this, some negative connotations have still lingered, namely that passive investing offers “passive performance” and that you need to “pay for performance”, that is, pay higher fees for active management to generate returns.

The historic data suggests this view is a fallacy.

Mr Wielandt points to research conducted by Standard & Poor’s over 18 years.

“The 29,000 data sets basically [show] that if you’re trying to be active and outperforming the market, you’ve got a 95% chance of failing. And of the 5% that succeed, if you look at them over the next five years, only 5% of the 5% will succeed,” he says.

This research is supported even by recent data.

“One of the SPIVA reports for last financial year, so take away COVID, also suggested that in 2019, for the financial year, almost 93% of active managers underperformed the ASX 200. And that number also persists at 83% underperformance over three years and 81% underperformance of the index over five years,” says Mr Pochynok.

This isn’t to say there isn’t a place for active investments, but rather investors should be selective in using them and seek to identify those consistent performers.

Passive with active overlay for clients

The switch to using passive investments in an active way reflects a change in attitude for advisers as well as their clients.

Mr Wielandt says, “two years ago I would have said that we were more just choosing direct equities…But certainly over the last eighteen months we've been far more using ETFs and passive ETFs and, as you're saying, sort of using ETFs in a passive tool in an active manner…There's some difficult conversations happening with clients that have got this direct equities focus, that have got that mindset. That was a 1990s mindset. 2020 today, and it's about total return. It's about broad asset allocation and terrain. You're using passive tools but in an active manner.”

He notes that the Australian market is behind global counterparts in terms of how it’s using passive investments like ETFs but will get there eventually, following the path of countries like Canada with a similar environment to Australia.

The choice to use passive investments in an active way will continue to be something investors and advisers grapple with across the coming years.

For Mr Pochynok though, it has been a simple decision that comes back to the value proposition he offers to his clients.

“Looking at it from a macro perspective, the real value that advisers bring is solving big rock problems for clients, and making their lives simple, efficient and providing them with effective solutions,” he says. From his perspective, using passive investments to allow him to focus on active risk-management and client goals is a natural fit.