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SuperGuide – Passive versus active: Which investment style is best in a downturn?

David Hancock features in this article on written by Alexandra Cain. To view the original article click here 

It’s tempting for self-managed super fund (SMSF) investors to switch their attentions from low-cost, passive investments to actively managed strategies when markets are volatile and falling. But it’s more important than ever to work out the right trade-off between performance and fees to help preserve precious capital.

A passive strategy tracks a market index, such as the ASX 200. The investment will mirror the performance of the benchmark it tracks, in this case the top 200 Australian companies listed on the Australian Securities Exchange (ASX). This tends to be a long-term buy and hold strategy and investors understand there will be market volatility along the way.

“Passive investing is seen as a low-cost way to generate returns as you’re not relying on a portfolio manager to choose stocks. You also retain the rights to any dividends and distributions from the portfolio’s underlying assets,” says AMP financial planner Andrew Heaven.

In an actively managed share strategy, a professional portfolio manager makes decisions about how to invest the fund’s money. The goal is to outperform the market and index. Investment managers look for ways to maximise profits while mitigating risks. For instance, they may try to identify companies whose share prices are undervalued because they think they can see an opportunity for the business other investors can’t appreciate or don’t value highly enough.

“Passive investments such as index funds outperform the majority of active strategies over time,” says Montara Wealth director David Hancock.

“This is because passive strategies generally have a lower cost structure thanks to low investment fees, as well as fewer transactional costs and taxes,” he adds.

That said, Hancock says in times of market volatility an active strategy that has the flexibility to minimise downside risk could prove more beneficial. “But it depends on the active investment’s scope. Most have to trade within certain parameters.”

For example, an actively managed Australian shares fund might be able to sell down companies impacted by COVID-19 such as Qantas. But it will still hold other Australian shares that fall as the market drops.

Passive investment options

Exchange-traded funds (ETFs) that replicate different investment indices or sectors are becoming very popular passive investment options for SMSFs. There has been an explosion in these products across the asset-class spectrum including equities, property trusts, commodities and currencies, plus much more.

“Contrarian investing is an option within the passive investment universe,” says Heaven. This is when you invest contrary to prevailing sentiment – so you may buy equities investments when the market is falling and other asset classes when the share market is rising.

Listed or unlisted managed funds that offer exposure to share market indices are another option within the passive investment spectrum. You can buy unlisted options directly from fund managers and listed funds on ASX and other markets.

“You get the dogs and the darlings in a falling market when you buy an investment that replicates the index,” says Heaven. You’re essentially taking a bet on the market and hope there are more darlings than dogs.

The sheer volume of trading at the moment does mean passive investors face liquidity risks. This is the threat the underlying asset values may not be replicated in the ETF’s unit price, which might trade at a discount.

Advantages of an active approach

Actively managed investment funds and listed investment companies and trusts that trade on ASX are among the active options for SMSF investors.

In the current climate an active approach may provide an opportunity to cherry pick stocks and investments, avoiding riskier shares in the market.

“You can look at a volatile market as an opportunity to buy good quality stocks at lower prices as people sell out,” advises Heaven. But understand you rely on the portfolio manager’s skills with an active approach and there’s a variety of skill levels in the market.

Says Heaven: “Managed funds and listed investments have different pros and cons. Managed funds tend to reflect the underlying value of the assets. Whereas you may find in the current market a listed investment trust trades at a discount to net asset values as people move out of the market quickly.”

Make sure any actively managed funds you invest in are true to label and invest according to their underlying philosophy, which you will be able to find in the product disclosure statements and on the website.

You don’t want to buy something you think invests in a particular way and then the portfolio manager invests in assets that don’t meet your expectations. Ethical investing is an example. Some funds claim to be clean and green but may invest in areas such as fossil fuels you’d prefer to screen out.

Also make sure you pay for what you get. Some portfolio managers are expensive so consider whether they offer value for money. Check the fees are not higher than the performance the fund aims to achieve.

“Active managers tend to outperform passive managers in a volatile market. But the overarching principle is you need to be very wary of the risks associated with the momentum in the market,” Heaven recommends.

So, if you’re investing in passive assets and money is leaving the market, this will have a negative impact on the market as a whole and the value of your investment.

With an active approach, the fund manager makes the call to enter or exit the market on your behalf. If they are skilful – and correct in their assessment of the market – they can stem your losses or even make gains in a falling market. But be aware those managers are few and far between and their wins may be due more to luck than skill. Always remember past performance is never an indication of future performance.

“Trying to time the market by moving in and out assets can do damage. You’re often far better hanging in there and investing on the basis of your overall time frame,” Heaven adds.

Whichever your approach, the best option is to ensure the way you invest is still aligned to your investment goals to achieve the best return over the long term.

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