March 2024

The real cost of passive investing¹

The debate between passive and active investing is often presented in black-and-white terms. Investors can choose to either use passive funds that track an index or favour active funds that aim to outperform an index.

Both styles of investing – or a combination of the two – can help investors achieve their goals. The key is understanding the pros and cons of each investment style and making an informed decision.

The trouble is, many investors base their decision mostly on fees. In doing so, they favour lower-cost passive funds over higher-cost active funds. 

Fees are important. But they tell only part of the story. Some passive funds have higher risks than many investors realise. Active fund managers use portfolio manager expertise to take calculated risks. If successful, they can earn their fees many times over.

Start with risk. The Australian sharemarket (by market weighting) is dominated by large banks and mining companies. US sharemarkets are dominated by a small group of giant tech stocks. As a result, investing in passive funds that track these indices means greater exposure to a narrow group of sectors or stocks. That’s the risk of index concentration. Active managers are not anchored to the dominant weights in the index and may be well positioned to navigate an evolving market landscape.

Next, consider index constituents or ‘what’s beneath the hood’. The Australian sharemarket has some great companies and also some low-quality, overvalued ones. With an index fund, you get ‘the good, the bad and the ugly’. An actively managed portfolio can offer investors access to a concentrated portfolio with deeply researched and hand-picked high-quality companies.

Index momentum is another consideration. We mentioned earlier that index funds hold stocks based on their index weighting.

When company A rises in value (and has a higher index weighting), the index fund must own more of it. When company B falls in value (and has a lower index weighting) less of it is held. 

As a leading active investor, PM Capital does the opposite. We aim to buy high-quality companies when they are undervalued and sell when they are overvalued. Often, that means buying stocks after they have fallen, and selling after they have risen. 

Finally, think about market volatility. Capitalising on volatility creates opportunity and is one of the keys to earning attractive long-term returns.

Index funds aren’t designed to capitalise on volatility. Active funds, such as those offered by PM Capital, have portfolio managers using their market experience to try to pinpoint stock opportunities during volatility.

When markets fall, index-fund investors receive the index return – which in some years is negative. They don’t have the sophistication of experienced portfolio managers trying to capitalise on volatility.

Then there’s returns. Successful active managers outperform their benchmark index over short and long periods, after fees. Their funds cost more than passive funds but the successful active manager aims to provide returns in excess of an index.

PM Capital’s Global Companies Fund, Australian Companies Fund and Enhanced Yield Fund have each delivered attractive, excess return over their benchmark index – after fees – since inception².

Choosing how to invest goes beyond just fees. Active management can add value by navigating risks, seizing opportunities – even from volatility, and potentially delivering higher returns even after fees. While passive funds offer simplicity and can be an effective way for investors to achieve their financial goals with minimal effort and cost, successful active strategies can offer expertise to make the most of market dynamics.
 

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Notes and references

¹Assumes passive index funds that track broadbased, market-weighted indices.
²Past performance is not a reliable indicator of future performance.
 

This insight is issued by PM Capital Limited ABN 69 083 644 731 AFSL 230222 as responsible entity for the PM Capital Global Companies Fund (ARSN 092 434 618), the PM Capital Australian Companies Fund (ARSN 092 434 467) and the Enhanced Yield Fund (ARSN 099 581 558), the "Funds". It contains summary information only to provide an insight into how we make our investment decisions. This information does not constitute advice or a recommendation, and is subject to change without notice. It does not take into account the objectives, financial situation or needs of any investor which should be considered before investing. Investors should consider the Target Market Determinations and the current Product Disclosure Statement (which are available from us), and obtain their own financial advice, prior to making an investment. The PDS explains how the Funds' Net Asset Value are calculated. Past performance is not a reliable guide to future performance and the capital and income of any investment may go down as well as up.