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

 

  1. Low turnover versus high turnover

 

  1. 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.

  •   11 May 2017
  • 2
  •      
  •   
banner

Most viewed in recent weeks

Why spending more in early retirement can improve lifetime income

Conventional wisdom encourages retirees to preserve superannuation. But if those likely to qualify for the Age Pension later in life spend a little more today, it may deliver higher lifetime income and a more stable retirement.

Testamentary trusts have secured the CGT exemption

Treasury’s latest CGT reform draft delivers a win for testamentary trusts and deceased estates, exempting estate-derived gains from the 30% floor. However, questions on death and divorce rollovers remain unresolved.

Meg on SMSFs: What do we think about reversionary pensions these days?

Reversionary pensions have long been a staple of SMSF estate planning, but are they still the best option? Meg Heffron revisits a once-clear favourite and asks whether changing super rules have shifted the balance.

Is it time to bail on Australian stocks?

For generations, Australian investors have backed banks, miners and dividends. But has that loyalty come at a cost? A look at the numbers raises an uncomfortable question about where future returns will come from.

How does the 4% rule stack up?

The 4% rule has long been retirement's gold standard. But after a difficult period for investors, fresh analysis suggests a more conservative approach may significantly improve the chances of making savings last.

Testamentary trusts survived the trust tax. The drafting battle has just begun.

The fight over testamentary trusts looked settled. Then the draft legislation arrived. Hidden in a technical detail is a question that could force many families to rethink wills they thought were already future-proof.

Latest Updates

Planning

How the typical Australian Family could save $844,350 in taxes

The value of a testamentary trust is not determined by wealth alone. Depending on circumstances, it can reduce the tax burden on inherited income, create efficiencies and help build intergenerational wealth.

Superannuation

There's a reason why your super is locked up until your 60s

For decades, it seemed settled. Then one controversial idea reignited a debate that could reshape the financial future of millions. The real question isn’t who’s right or wrong, but whether a long-held assumption deserves another look.

Property

The housing slide could become a crash

House prices are sliding across Australia, yet the most dangerous ingredient for a housing crash is still missing. If job losses surge amid growing economic risks, today's correction could become a historic property downturn.

Retirement

Under-retiring: The greatest retirement risk in a generation

Two retirees. Similar savings. Completely different lives. New research from Challenger reveals why some Australians confidently spend in retirement while others hold back and the overlooked factor shaping retirement decisions.

Five risks to watch in markets

Things you may often hear are: a recession is around the corner, markets are overpriced, the AI sector is about to flop at any moment. It’s like the never-ending laundry pile that sits in my house, it never really disappears.

Investment strategies

Do you qualify as ‘rich’?

What does it mean to be 'rich'? For something so universally desired, it is surprisingly difficult to define. That ambiguity creates a challenge for investors and raises a bigger question about what financial success really looks like.

Investment strategies

If you’re worried about your bond portfolio, you’re missing the point

Most investors think they know what bonds are for. But when markets turn volatile, a surprising misunderstanding can lead to costly decisions. Here’s the overlooked lesson that could change how you view your portfolio.

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 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.