Active and passive – getting the best of both worlds

Sponsored by Bennelong Australian Equity Partners (BAEP), a Bennelong boutique. 

The rising popularity of index funds and ETFs has brought with it a step-up in the debate on the merits of passive versus active investing. Often lost in this discussion, however, is a true understanding of the different approaches and how they can both benefit investors at different times.

The popularity of passive investing in recent times is easy to understand. In the constant drive to reduce fees, index funds and ETFs seemingly provide the ideal solution.

For instance, one of the more popular passive funds, the Vanguard Index Australian Shares Fund[1], matches the return of the S&P/ASX 300 Index and charges just 0.35%-0.75% in fees[2]. Many actively managed equity funds, in comparison, charge around 0.95% on average and quite often still hug a benchmark. 

Many investors pay these higher fees in the belief that active funds will outperform the market – but in reality only a handful of funds consistently do.

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The struggle for outperformance

There are several reasons why many core active equity funds have trouble outperforming, but one of the major ones is from the heavy concentration of the market in the top 20 stocks.

The Australian market is concentrated like no other. These “mega-cap” stocks account for 58% of the total value of the S&P/ASX300 Index[3].  It helps that these top 20 stocks are the most liquid and that heavily weighting them means less risk, at least in terms of tracking error.

As a result, it’s not unusual to see actively managed funds made up of the big four banks and a handful of other large cap names such as BHP, Telstra and Wesfarmers.  But this makes it difficult to differentiate from the index or peers – doing the same thing as everyone else generally creates the same result.

So while it is easy to understand the popularity of passive investing, the debate on the merits or otherwise of this approach is more complex than a simple either-or approach. In fact combining the two approaches can truly provide the best of both worlds.

There’s a place in investors’ portfolios for both passive and active investing; it all comes down to when you can and can’t add value from paying for active investing.

Where there are genuine prospects for outperformance, there is a good argument to be made for paying fees. In our view, this arises outside the top 20 stocks, in the lesser known parts of the market. A case in point is BAEP’s Bennelong ex-20 Australian Equities Fund. This fund has outperformed its benchmark by 7% p.a. since inception[4], and its outperformance has been quite consistent over time.

The main reason why skilled fund managers can consistently outperform in this space is that this is where the value-adding opportunities are generally found, and where skill and effort are rewarded with finding them.

Many companies outside the top 20 are covered by just a few brokers – and in some cases, none at all.  The result is a less efficient market in which favourable risk/return opportunities more frequently arise; there’s more potential to outperform the market by undertaking extensive proprietary research and profitably applying sophisticated analytical skill through active management.

Combining passive and active

Passive investing has its place, and in Australia, that seems to be in the top 20 where the prospects for outperformance are limited.  

Active fees are better spent where they earn more ‘bang for their buck’, that is, in the ex-20 market. Combining the two can deliver the best of both worlds.

Capitalising on this concept, the BAEP 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 employed in 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. 

The Twenty20 Fund leverages BAEP’s wealth of experience and aptitude in actively managing ex-20 money and indexing the top 20, giving investors access to a cost efficient vehicle that incorporates active management where it most reliably adds value.