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.

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

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.

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.

The new capital gains tax trap for your portfolio

Investors have long accepted one portfolio rule without much question. A major tax shift could change that calculation entirely, forcing difficult trade-offs between risk, discipline and an overlooked cost lurking beneath.

The investing rule that explains the next market crash

What if investment success depends less on picking the right assets and more on understanding the decisions of other investors? A principle borrowed from game theory offers a different perspective on markets.

Latest Updates

Fixed interest

Higher yields are creating opportunities in global bonds

Bond markets are adjusting to a new reality, but not in the ways investors expect. With markets repricing and capital competing for attention, investors may need to rethink where resilience and opportunity lie. 

Economy

Are we in a recession?

What if the warning signs are already everywhere? From supermarket aisles to company failures, investors are being bombarded with recession signals. But most face a different risk that can be just as dangerous for portfolios. 

SMSF strategies

Meg on SMSFs - Division 296 actuarial certificates

The tax bill might be yours, but the event that caused it may not be. A key Division 296 calculation can sometimes attribute earnings in ways that many SMSF trustees won't instinctively expect or fully appreciate.

Property

The first impact of negative gearing reform is not the tax bill

Negative gearing changes formally begin in 2027, but the first consequences may already be here. A subtle shift is quietly influencing who can borrow, how much they can access and which property strategies still stack up.

Economy

The oil market is running out of easy answers

The biggest threat to markets may not be what investors are watching. The numbers have stopped adding up and supply is harder to measure, with forecasts becoming simple guesses. A more fragile reality is being masked.

Investment strategies

The state of investor knowledge in Australia

Australians are investing more than ever, yet a surprising divide is emerging between those building wealth effectively and those making costly mistakes. Surprisingly, the gap has little to do with income, age or starting capital.

Taxation

Complexity and capital gains

A case study shows that the ‘30% minimum CGT’ is a poorly conceived tax that adds significant complexity to an already over-complex system. A less complicated model would create a much fairer progressive tax scale.

Sponsors

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.