MONEY: Tips on deciding how to allocate and invest retirement funds, choosing active over passive.
MONEY: Tips on deciding how to allocate and invest retirement funds, choosing active over passive.

Good advice on active and passive investment choices

SHOULD you trust the sharemarket with your money and get whatever return it produces or is it worth paying an extra fee to active investment managers who chase "better than average returns”?

The question is in the headlines just now with active managers forced to justify themselves in the face of popular "passive investing” often based on exchange traded funds.

Investment powerhouse Vanguard has released a so-called "white paper” that aims to help investors answer this question and allocate between passive and active investment.

Deciding how to allocate and invest funds is usually one of the most challenging decisions that people face, as the outcomes are varied and usually life changing.

If you had a $500,000 portfolio that returned 4 per cent per year, you would have $740,122 at the end of 10 years, but if you managed to achieve 8 per cent per year, you would have $1,079,462, a whopping $339,340 difference.

Vanguard put forward a simple case that active managers find it hard to outperform over long periods and that the more fees you pay, the harder it is for you to beat the average market return.

In addition, by adding active management, you are introducing manager risk, which will result in a wide range of outcomes from more returns with less risk to less returns with more risk.

In what Vanguard terms a "decision making framework” it puts a range of four variables for consideration in deciding if you should be passive or active.

The variables

  • Do you have the necessary time and expertise to pick outperforming investment managers yourself, or do you have a financial planner to help you find the right investment managers?

If you say no, Vanguard recommends that you allocate all your money to passive strategies. This typically would in the form of something like an index balanced fund that allocates your money in a non-active way to cash, bonds, property and shares, giving you a blended return.

  • If you do have the capability or professional relationship to identify outperforming investment managers, the next step is to think about how much extra return you expect to get by being active, and if it outweighs the additional cost.

If there is no expected net benefit, Vanguard again recommends that you be passive and invest in index strategies.

  • The penultimate step is to consider how much extra risk you are taking by being active and the last step is to decide how comfortable you are with that uncertainty.

In other words, if you choose an active investment manager, are you willing to see your range of returns widen, with more deviation from year to year, both positive and negative?

If you're not comfortable with this, passive management is recommended.

In the white paper, there is a matrix of allocations based on the above process.

  • Of the 135 potential outcomes, 90 suggest passive strategies and a mere 13 suggest you might invest in active strategies.

With Vanguard being the largest passive investment manager in the world, it is safe to say that it would put out a white paper that didn't improve its cause.

So as with all commercially produced reports, the Vanguard one should be taken with a grain of salt.

Performance

But there are some strong take-outs here: it is indeed difficult for an investment professional to outperform the market for long.

The numbers vary depending on the data set, but its usually along the lines of 80 per cent of active managers will underperform a passive strategy over 10 years. So the data say that you only have a one in five chance of picking an active manager that will benefit you long term.

If this is the case, shouldn't all investors just inject their money into the indexes for bonds markets, property markets and sharemarkets with a set and forget mentality? In my opinion, it depends on circumstances.

For someone who is retired, capital preservation and generating a sufficient income to support living expenses are generally the two main considerations.

Assuming risk tolerance that justifies sharemarket investment, a passive investment approach would generate dividend income of 5 to 6 per cent each year.

However, by using an active manager who has a dividend rotation strategy, for example, whereby they buy stocks in the run-up to declaring a dividend, hold for 45 days, then sell, this can increase the dividends closer to 10 per cent.

In addition, assuming the money invested was in a super pension, the capital gains tax effect of all that trading is eliminated due to the zero tax environment. So in some cases, using an active manager can improve the chances of achieving an investment goal, such as generating a higher level of income.

In fact, there are active managed funds set up specifically to target different investment needs and investor groups.

For me, there is no clear winner in the active versus passive debate. They both have their place in most portfolios.

It's more about understanding your own needs, then seeking out the right mix of investments to best fit them.

If it is beyond your skill set or interest to undertake this exercise yourself, a licensed financial planner will be able to plot a course in the right direction for you.

The last tip is to make sure that your chosen financial planner is looking at your needs first and not their own, but that is a whole other conversation.

James Gerrard is the principal and director of financial planning firm FinancialAdvisor.com.au.


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