To best answer this question, you need to consider what are the advantages of a passive approach to investment in general. The biggest advantage to passive investing is that it replicates the movements of a particular index. In its simplest form, passive investment is buying a series of stocks, property etc and trying to replicate a benchmark index; for example, that of the ASX. 

Passive investment is often seen as a low-cost and low-governance way to invest, as you’re not relying on a portfolio manager to choose stock for you. You have the control as the investor.

Because you’re not relying on research for selection of investment and you’re trying to replicate the index, passive investments can be cheaper to purchase and manage. Additionally, you will retain all rights to dividends and distributions from the underlying assets of the portfolio. 

What sort of passive investments could SMSFs look at at the moment and why?

Presuming the client is happy owning passive investments for their SMSF in the current market, it would be worthwhile looking into exchange trade funds (ETFs), which replicate particular indices or sectors. For example, ETFs can be in equities, property trusts and even commodities, such as gold currency. Another option for passive investments is contrarian investments, when it is undervalued in a weaker environment and then selling when the situation is improved. 

Additionally, you can purchase managed funds that are listed or unlisted. Unlisted funds are along the lines of vanguard funds, and you can purchase them directly from the fund manager themselves. 

Are there any risks involved in this type of investing in the current climate, and how can they be managed?

As with anything, it all comes down to timing. If you buy an ETF and the market falls, you’re relying on the market to come back up, otherwise you’re going to end up underwater.

A key principle is that in this type of market, replicating the index, you’re buying “the dogs and the darlings”.

Arguably, not all companies are going to come out of this alright with the prevailing market conditions they face, so therefore you’re taking a broad bet, for lack of a better word, on the market, and you’re hoping that there are more “darlings” than “dogs”. 

You also face liquidity risk due to the sheer volume of trading at the moment. The risk is that the underlying asset values might not be replicated in the unit price of an ETF, which is a result of the sheer volume of trading that is happening at the moment. As a result, the market makers can’t keep up with the volatility of the underlying stocks. 

There are ways to avoid this. When you’re buying an ETF on market, buy it at a price that you’re prepared to pay and a cost that you’re prepared to part with, don’t buy it at market price. 

Additionally, if you’re buying an ETF that is offshore, try and avoid buying when those markets are closed or at the beginning and end of the day, as the price of the ETF may not reflect the underlying asset value.  

What are the advantages of an active approach to investing in the current market?

Given the current climate, the advantages of an active approach would be that it is an opportunity to cherry-pick stocks and investments, avoiding the riskier stocks in market. In many ways, you can look at a volatile market as an opportunity to buy good quality long-term stocks at lower prices as people sell out. 

With an active approach, you’re also relying on the skills of the portfolio managers themselves to invest in what they feel are viable companies going forward. 

What sort of active investments could SMSFs look at at the moment and why?

SMSFs could look to buy managed funds and could certainly do so directly from the fund managers or via wrap structures. They can also buy listed investment companies, which will list investment trusts, which will trade on the ASX. 

Both managed funds and listed investments have their pros and cons. For managed funds, they tend to reflect the underlying value of the assets. Whereas a listed investment trust you may find in the current market is trading at a discount to net asset value as people move out of the market quickly. 

Are there any risks involved in this type of investing in the current climate, and how can they be managed?

As with any investment, timing is everything, as you may end up on the wrong side of the trade. If you have a disciplined approach to entering the market, you could go in with one lump sum or dollar cost averaging, and the risk you face is that if you miss the market, the opportunity may have already gone. 

If investing in active managers, i.e. portfolio managers, make sure that they are true to label. In other words, they invest in accordance with their philosophy standpoint. You don’t want to buy into something that you think is invested in a particular way and then the portfolio manager invests a different way. Ethical investing is an example of this. 

Make sure you’re paying for what you get, some portfolio managers are very expensive, so it is important to consider whether or not they are offering value for money. 

What else should SMSFs be thinking about in terms of passive versus active investing at the moment?

In a volatile market, active managers tend to outperform passive managers. But the overarching principle is you, as an investor, need to be very wary of the risks of momentum in the market. This means that if you’re investing in passive assets and money is generally leaving the market, that will have a negative impact on the market as a whole. Therefore, you’re not getting the opportunity to assess the intrinsic underlying value of the shares. Whereas if you’re using an active approach, the fund manager is making these calls on your behalf. 

On the balance of probabilities, moving in and out of markets, we can do more damage by trying to time the market. We’re far better off, hanging in there and investing on the basis of your overall time frame.

Andrew Heaven, of Wealth Partners Financial Solutions, is an authorised representative of AMP Financial Planning.