NEWSLETTER

Understanding the investment styles

active and passive

No detailed analysis A  ims to replicate the performance of a market

 Fund manager conducts rigorous research Aims to beat the market  Maximise gains and minimise losses

ACTIVE

When investing ones money, one of the choices facing investors is an active or passive investing style. It is important for an investor to understand the main principles of each style before determining which one or a combination of the two is most suitable for their particular investment objectives. This fact sheet sets out to explain the differences between these two investment styles to aid investors in their discussions with their financial adviser on choosing the most suited approach.

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Passive investing
Passive investing or index tracking refers to when investors buy a fund that follows the performance of a given index. For example, if one wants to have access to the FTSE/JSE Top 40 Index, investors can buy into a fund that tracks the performance of the index by owning a representative sample of the total shares on the FTSE/JSE Top 40 Index. The fund that one invests into is either a unit trust fund that is set up as an index tracker or, more commonly, an Exchange Traded Fund (ETF). An ETF tracks the performance of a given index and provides investors with the returns positive or negative of that index. In addition to tracking an entire index, ETFs can also track a component of an index, such as only the top shares, financial shares, or only industrial shares. Index-tracking funds have been available since the 1970s in the US and are now widespread globally. Each fund attempts to index or track a particular index or portion of an index. ETFs are a relatively new fund vehicle, having been available for the last 10 years. Ultimately, however, each fund is aiming to do the same thing track the performance of a given market. An important overriding principle of index-tracking or passive investing is that its a strategy designed to match a market, not beat it. The performance of an index-tracking fund or ETF will mirror the performance of the index or market it is tracking. Therefore, if the FTSE/JSE Top 40 Index performs positively, for example, the ETF tracking the index will produce a positive return. The ETF will produce a negative return if the index performs negatively. The manager of an index tracker or ETF acts very much as a financial adviser accepting instructions from investors to buy or sell a given percentage depending on how much they want to invest. When a fund invests in a component of an index, the fund manager is responsible for rebalancing the portfolio in line with changes in the shares of the index. Due to the fact that these funds track an existing index or market, the input required from the fund manager is relatively small, hence this investment style is known as passive investing. In South Africa, investors have access to several ETFs that track different components of the market. To name but a few, investors can track:  An index that constitutes the 40 largest companies, by market capitalisation, listed on the JSE Securities Exchange.  The top 15 financial institutions in South Africa, including the countrys five largest banks, other general financial companies, property companies, plus the main long-term and short-term insurance companies.  Resources-based stocks, including mining companies, mining holding companies, mining finance and exploration companies and resource-based stocks, such as Sasol. While a fund managers role in managing an ETF or index tracker fund is passive, the role of the fund manager in the active investing style is somewhat different.

Index tracking, or passive investing, is a strategy designed to match a market, not beat it.

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Active investing
Active investing is when one invests in a fund that is actively managed. Active fund managers seek to beat the markets returns as opposed to only giving investors a replication of the markets returns as seen with index-tracking or passive investment funds. Managers following an active investment style use various methods to outperform a given index or benchmark. The essence of their approach is to capitalise on what they believe are pricing inefficiencies in the market. They conduct detailed research on companies and stock prices and compare their valuation of those stocks to that of the market. The majority of this analysis includes evaluating a companys past, current, and future earning capability with forthcoming business and economic conditions. The outcome of their analysis is compared to the companys past, present, and forecasted stock price. The managers intention is to buy a companys stock when they believe it is undervalued, and to sell that stock when it is overvalued, thereby creating a profit for their fund. Managers will also attempt to identify economic trends to help them predict which industries have the best near term prospects and avoid those with a less favourable near-term outlook. Investors have a plethora of actively managed investment funds to choose from in South Africa and internationally. The range of actively managed funds includes equity funds, bond funds, balanced funds, specialist funds, global funds and emerging market funds. For each type of investment strategy, fund managers follow a detailed, methodical research process to identify and choose the stocks that they believe will provide the greatest performance within their fund. Actively managed funds aim to beat a market or an identified benchmark.

Active fund managers seek to beat the markets returns.

Comparing the two investment styles

When one aims to compare active and passive investment styles, one has several important factors to consider, such as the level of fees and the expected risk and returns of each investment style. The investment decision-making process requires more time and resources for active managers, and as such, they typically have higher management fees. However, the managers success may vary and typically results in more volatile investment returns relative to the index. Conversely, passive or index-tracker managers typically charge lower management fees for a more simplified investment process of matching the returns of an index. For the active style, the risk is more manager-driven while for passive investing, the risk is more market-driven. Given the nature of the investment styles, index-tracking investors are always fully invested to the index (or component of the index), meaning the portfolio will hold a proportion of just about every stock in the index and little to no cash as an asset. This subjects the portfolio to market swings, which proves rewarding during market upturns, but costly during protracted market declines. Active managers on the other hand, vary the type of stocks and amount of cash held in the portfolio based on their opinion of market conditions and stock prices. These are typically rewarding during market upswings, and can be less costly during market declines.

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Differences between active and passive investing Active investing

Fund manager
 Conducts rigorous research and analysis on company stocks.  Makes informed investment decisions for the fund.  Fulfills an intensive management role.

Passive investing
 Fulfills a passive management role.  No detailed analysis or significant investment decisions required.

Performance

 Aims to beat the market or beat a stated benchmark.  Has the ability to maximise gains and minimise losses.

 Does not aim to beat the market or a benchmark.  Aims to replicate the performance of a market positive or negative.  Cannot make gains greater than the market.  Lower management and operating fees.

Fees

 Manager fees are higher due to increased levels of skill, knowledge and involvement required on behalf of the manager.

Risk

 Fund is exposed to manager risk as well as market risk.

 Fund is exposed to market risk.

Strategies

 A range of strategies for investors to choose from including equity funds, bond funds, balanced funds etc.

No choice of investment strategy.

Many studies have been performed to test whether one particular investment style in terms of active versus passive investing has proven more successful. Conclusive evidence has not been determined to support either strategy in totality. However, it should be acknowledged that both strategies have appealing characteristics and have seen varying degrees of success based on certain economic conditions, market types, and time periods. Moreover, the suitability of either investment approach, or a combination of the two approaches, is based on ones personal investment objectives and circumstances. Your financial adviser will be able to recommend investment funds that are suitable for your needs and that best fit your specific risk profile and investment objectives.

GM_16246DI_27/06/2012