Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 201

Active versus passive: there’s more to it

I am as guilty as most market participants of using the phrase ‘active versus passive’, when strictly speaking, that is not what I mean. The problem with using those terms is it glosses over some important details. As a simple example, a highly active investor can use index funds and a highly passive investor can use traditional actively managed funds.

What should the debate focus? There are three comparisons that immediately spring to mind:

  1. Low cost versus high cost
  2. Low turnover versus high turnover
  3. Rules-based versus forecast-based.

Low cost versus high cost funds

We have written at length about the costs of funds and ETFs. Costs are closely associated with performance. Numerous studies have confirmed this, starting with the work of Nobel Laureate William Sharpe in ‘Mutual Fund Performance’ written in 1966. It is not as if the thought is new, rather the marketing of more expensive investment options has been very effective.

Why do costs matter so much? Fees are taken directly out of performance daily and investors never actually see them. The less paid in fees, the more that remains for the investor, but it's not as simple as active equals expensive and index equals cheap.

Not all index funds are cheap nor active funds expensive

Source: Morningstar, Owners Advisory, May 2017

Low turnover versus high turnover

One metric that is often overlooked, but is extremely important particularly to after-tax returns, is turnover. Turnover measures the frequency in which securities are traded over a 12-month period and serves as a proxy for trading costs. Trading costs directly impact a fund’s performance (and again, like fees, are taken out prior to performance is calculated, making it difficult to see). In addition, capital gains can be locked in and then passed through to the investor. Traditional active managers and indeed some rules-based approaches have very high turnover, which investors pay for, and again impacts directly the returns realised.

Not all index funds have low turnover

Source: Morningstar, Owners Advisory, May 2017

Rules-based versus forecast-based

Rules-based investment strategies are what underpin nearly every smart beta offering or factor tilt investment strategy. Typically, rules-based approaches are based on academic research. Value, for example, is such a factor. Researched endlessly, in the early work by Fama and French, companies with low price-to-book ratios were identified as providing excess returns to the market over the long -term. Indeed, straight cap-weighted index funds, such as an investment that tracks the S&P/ASX 200 is another factor investment, but here the factor is beta or the market as a whole. These rule-based strategies do not care about the direction of the market. They simple follow the rules.

On the other hand, forecast-based approaches are typically seen in the traditional active management strategies. Analysts work to identify the ‘true’ or ‘fair’ value of a security using some valuation method and then look to see where mispriced securities may be lurking. This is a tough gig, particularly as technology improves. A well-designed algorithm can identify mispricings much faster than a human can. The impact is to push prices to their ‘fair’ value faster than was once the case.

Using the phrase ‘active versus passive’ is an oversimplification of the problem investors face when thinking about how to implement their asset allocation. Really, what ultimately matters is returns individual investment vehicles deliver, not whether they are index investments or not.

 

Leah Kelly is Portfolio Manager at Owners Advisory. This article is general information and does not consider the circumstances of any individual.

banner

Most viewed in recent weeks

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

The 2025 Australian Federal election – implications for investors

With an election due by 17 May, we are effectively in campaign mode with the Government announcing numerous spending promises since January and the Coalition often matching them. Here's what the election means for investors.

Finding the best income-yielding assets

With fixed term deposit rates declining and bank hybrids being phased out, what are the best options for investors seeking income? This goes through the choices, and the opportunities and risks involved.

What history reveals about market corrections and crashes

The S&P 500's recent correction raises concerns about a bear market. History shows corrections are driven by high rates, unemployment, or global shocks, and that there's reason for optimism for nervous investors today. 

Howard Marks: the investing game has changed

The famed investor says the rapid switch from globalisation to trade wars is the biggest upheaval in the investing environment since World War Two. And a new world requires a different investment approach.

Welcome to Firstlinks Edition 605 with weekend update

Trump's tariffs and China's retaliatory strike have sent the Nasdaq into a bear market with the S&P 500 not far behind. What are the implications for the economy and markets, and what should investors do now? 

  • 3 April 2025

Latest Updates

Investment strategies

4 ways to take advantage of the market turmoil

Every crisis throws up opportunities. Here are ideas to capitalise on this one, including ‘overbalancing’ your portfolio in stocks, buying heavily discounted LICs, and cherry picking bombed out sectors like oil and gas.

Shares

Why the ASX needs dual-class shares

The ASX is exploring the introduction of dual class share structures for listed companies. Opposition is building to the plan but the ASX should ignore the naysayers and bring Australia into line with its global peers.

The state of women's wealth in Australia

New research shows the average Australian woman has $428,000 in net wealth, 40% less than the average man. This takes a deep dive into what the gender wealth gap looks like across different life stages.

Investing

The two most dangerous words in investing

Market extremes are where the biggest investment risks and opportunities lie. While events like this are usually only obvious in hindsight, learning to watch out for these two words can alert you to them in real time.

Shares

Investing in the backbone of the digital age

Semiconductors are used to make microchips and are essential to a vast range of technology and devices. This looks at what’s driving demand for chips, how the industry is evolving, and favoured stocks to play the theme.

Gold

Why gold’s record highs in 2025 differ from prior peaks

Gold prices hit new recent highs, driven by a stronger euro, tariff concerns, and steady ETF buying – all while the precious metal’s fundamental backdrop remains solid amid a shifting global economic landscape.

Now might be the best time to switch out of bank hybrids

In this interview, Schroders' Helen Mason discusses investing in corporate and financial credit securities, market impacts of tariffs, opportunities for cash investments, and views on tier two and hybrid bonds.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.