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W & K

Passive Investing – Maybe you are paying too much?

Over the years there has been a lot of debate about the merits of investing in passive funds compared to actively managed funds. In the United States passive or index funds are very popular. There are even more passive funds than listed companies. Just because something is popular does not make them necessarily a good choice.

Passive investment funds’ performance has dominated active performance for the past five years in the United States. This is like what has occurred in Europe.

It is likely that the next ten years will be different to the past ten years. The global financial crisis was different to the great depression. Quantitative easing had not been used previously as a management stimulatory tool by the US Fed, Bank of Japan or the Bank of England.

The Russell Investments group have researched the active versus passive investment approach. Often a Russell index is used by passive funds. There is a cyclical relationship over time. Over the past thirty years there have been two extreme pro-passive cycles in large cap US shares. These were in the late 1990’s and in today’s environment.

It is not surprising in times when the bigger get bigger often through takeovers. The larger the company gets the higher the index weighting. It does not mean that the company is performing well or even has great prospects.

Active managers will screen out these large companies as they focus on the economic merits. They are often overweight mid-cap stocks and underweight the mega-cap stocks. They often prefer higher volatility stock. The average large-cap manager underperformed the Russell 1000 Index from 1994 to 1999. The average manager outperformed the same index in 2000 by 7.4%, with above average managers doing even better. This continued for the next five years.

If we look at the five years to September 2016, the Russell 1000 Index has outperformed the average active manager. This has been a period when low volatility stocks such as utilities and consumer staples have performed well. They comprise around a third of that index. Active managers have tended to be underweight them.

So, what is the answer? Remember that passive funds may be paying too much for the companies that they must invest in. A combination of active and passive funds may provide a smoother investment journey. Most research has been done on US managed funds. That may not be valid for a small market, like we have in New Zealand.

The directors of several large New Zealand companies have squandered billions of dollars in market capitalisation by making inappropriate investments in the past. Telecom, Fletcher Challenge, and Air New Zealand are examples of this in the past. Passive investors would have lost billions of dollars by being overweight in these large companies at the wrong time.


Steven Barton (FSP 32663) and Susan Pascoe Barton (FSP 32382) are Certified Financial Planners and Authorised Financial Advisers.  Their initial disclosure statements are available free of charge by contacting them on (07) 3060080 or they can be downloaded from www.pascoebarton.co.nz. This column is general in nature and should not be regarded as personalised investment advice.