Passive versus active investing

Passive investing is the strategy traditionally employed by index funds and exchange-traded funds (ETFs), whereby the manager holds a portfolio that mirrors the index, and no over or underweight strategies are employed. The investment objective of a traditional index fund or an ETF is therefore to track, but not outperform, its chosen index in the most cost-effective manner possible.

Passive investing has become increasingly popular in recent years due to low fees and the average active managers’ inability to outperform over the long term. In the United States, index funds now hold nearly half of the listed share market, while the ETF sector in Australia reached a record high $26 billion in funds under management in February 2017.

Exchange-traded funds (ETFs) are unitised investment funds that replicate an index, with the objective of mirroring the index’s returns. Units in an ETF are traded on the stock market like ordinary securities.

Conversely, active investing is a strategy whereby the manager builds the portfolio by evaluating stocks based on factors such as value, distribution, asset and manager quality. The fund manager can choose to take positions without regard to their size or benchmark weightings, including investing in companies with minor weightings, such as small capitalisation stocks.

The higher fees associated with active investing strategies should be rewarded with investment outperformance.

On a side note, active investing can also work with benchmark aware investing, to a limited extent. A benchmark aware fund manager, while restricted to selecting stocks based on the benchmark weightings, might also engage in strategic active investing by selecting stock weights within defined limits such as 5 per cent either side of the benchmark position.

Performance against a benchmark – what does it mean?

Investors need some way of tracking how their investments are performing, relative to the specific market sector, and in most cases, performance is assessed against the most relevant benchmark.

A benchmark is defined by the Australian Securities Exchange (ASX) as “a collection of assets that provide a broad representation of an asset class,” acting as a barometer for its performance. As an example, many Australian Real Estate Investment Trusts (A-REITs) will benchmark their performance by either the S&P/ASX200 A-REIT index, or the wider S&P/ASX300 A-REIT index.

At 31 July 2017, the S&P/ASX300 A-REIT index comprised of 31 companies covering retail, office, industrial, logistics and specialist sectors. Each company has a specific weighting in the index, depending on market capitalisation (company size as measured by stock price). At 31 July 2017, this index had a market capitalisation of $125.3 billion in total.

An index fund manager will build a portfolio purely based on the composition of the index and the weighting of each individual stock. An index fund manager will therefore take no strategic positions and consequently will be expected to return a performance exactly the same as the relevant benchmark.

The constraints of index investing

The domination of certain indices by large capitalisation stocks should be considered as it can significantly reduce diversification for an index investor.

In the case of the S&P/ASX300 A-REIT index, the top 10 index constituents accounted for 86 per cent of the overall index as of 31 July 2017. The performance of a small number of companies therefore can have a material influence on the index’s overall return, and in an index investment strategy, can expose investors to being heavily weighted to a very small number of stocks.

Furthermore, indexes can be heavily weighted to certain sub-sectors. In the case of the S&P/ ASX300 A-REIT index, the retail sector accounts for more than 50 per cent of the benchmark, and this too can impact on overall benchmark performance.

For example, in the year to 30 June 2017, concerns about the retail sector due to the “Amazon effect” hit large-cap retail A-REITs such as Scentre Group, Vicinity Centres and Westfield Corporation particularly hard, with returns of -13.4 per cent, -17.3 per cent and -21.5 per cent respectively.

The potential sitting outside the index

The S&P/ASX300 A-REIT index also excludes smaller REITs with market caps below $350 million. Some of these have performed well, including Centuria Metropolitan Office (up 25.5 per cent in fiscal 2017) and Australian Unity Office Fund (up 11.4 per cent). In fact, the median performance of the smallest eight A-REITs in the index was a positive 9.9 per cent, although the impact on the total index return was minimal due to the much smaller weighting of these stocks.

In such an environment, benchmark unaware managers have an opportunity to outperform. Without the requirement to maintain benchmark weightings or invest exclusively in benchmark stocks, they can invest in a much wider range of stocks.

A benchmark unaware strategy also allows for the potential to reduce volatility, with the opportunity to diversify across a wider selection of stocks, and no requirement to own a “risky” stock purely because it is part of the index.

For property investors, index and benchmark unaware styles both have advantages and disadvantages, with the benefits of the former including the lower costs, comfort of tracking the index and not being reliant upon an investment manager’s skills. Yet with the performance of the S&P/ASX300 A-REIT index masking wide disparities in stock and sector weights and returns, a benchmark unaware active approach can provide skillful managers with the opportunity to potentially deliver superior returns.

Hamish Wehl is head of retail funds management at Cromwell Property Group.