As an investor, you might not be aware of the difference between active and passive unit trust funds – but in the investment fraternity, there has been a fierce debate raging between the proponents of these two investment styles for some time. To understand the difference between actively run and passively run unit trust funds, we need to go behind the scenes and look at what they represent.
What is a unit trust?
A unit trust is an investment product consisting of a collection of shares, bonds, cash, property or other securities, managed by a professional. Every unit trust has a specific mandate according to which the fund has to be managed and will also have a benchmark against which the performance will be measured.
As an investor, you have to choose what type of investment exposure you require and then match the mandate of the unit trust to your requirements. For example, if you want exposure to the South African equity market, you will choose a unit trust with a mandate to invest only in South African equities listed on the JSE.
What is an actively managed unit trust fund?
These are funds where the professional managing the fund will apply his or her expertise to choose the best securities within the given mandate to try and outperform the average. For example, a fund manager with a mandate to invest in South African equities, will do in-depth research and analyze the financials of some specific companies on the JSE All Share index, and then choose a few that he or she believes will outperform the others.
Because there is a lot of work involved in researching and choosing the specific companies, a fee is charged for managing the fund.
- The advantages of these funds are that if done properly, the fund will outperform the average security that comprises that specific group and also lower the overall risk attached to that specific asset class due to the ability of the manager to participate in the upside and prevent some of the downside performance.
- The disadvantages of these funds are that the management fees are higher and it can happen that the manager is so worried that the performance of the fund will not beat the benchmark, that he or she deliberately chooses securities that mirror the performance of such a benchmark.
What is a passive unit trust fund?
These are funds that mirror the benchmark of the specific group of securities you want exposure to. If you want exposure to the South African equity market, a passive fund will basically invest in the South African Top 40 index.
Because there is not as much work done to include or exclude certain securities, these funds are usually cheaper to invest in than actively managed funds, but will also have the negative aspect of not being able to avoid potential bad performance in that specific sector.
To determine what type of unit trust will be suitable for your investment portfolio, you have to consider the following:
- The performance of an actively managed fund is inextricably linked to the ability of the fund manager.
- If we take for example the difference between the best and worst performing funds in the South African General Equity category over a five-year term, we see that the best fund produced 27.95% per annum and the worst fund produced 5.10% per annum. The average return for this category was 16.20%.
- It is very important to know that the best actively managed fund in a specific year is not necessarily the best fund the next year.
- If we take the South African General Equity category as an example again, you will see that the best fund over the first three months of this year ranked 67 out of 98 funds over a five-year period.
- Active funds do not always outperform passive funds.
- If we look at what happened over the first three months of this year, we see a passive fund that tracks the SA Top 40 index with a performance of 8.64% outperform the average fund in the active category with a performance of 1.90%, but underperformed the best fund with a performance of 9.01%
- If we take the performance over a five-year period, the same applies. The passive fund delivered 18.42%, while the average active fund only delivered 16.20%. The best active fund did outperform with 27.95%.
- The same applies over a twenty-year period. The passive fund gave you 12.70%, the average active fund gave you 11.52% and the best active fund gave you 13.87%. The risk here was that the worst performing active fund over a twenty-year period gave you only 7.66% per annum, which is a wealth-destroying return relative to just investing in the index.
Conclusion
There are actively managed funds that consistently outperform the passive funds in their specific mandates, but on average a passive fund outperforms the average active fund.
If you don’t have a financial advisor who can help you choose the funds to invest in, you might choose an underperforming active fund, or jump between funds due to their inconsistent performance, falling into the age-old trap of selling low and buying high.
In addition to active and passive funds, there is also a different kind of financial instrument that you can invest in called an Exchange Traded Fund (EFT). ETF’s come in various degrees of sophistication, ranging from a basic broader index tracker like a Satrix Top40 ETF, to a very sophisticated one that tracks a very specific sector like the Sygnia Itrix 4IR global ETF that invests in the top technology companies. These ETF’s are not actively managed but do provide much more sophistication for the knowledgeable investor. Using a combination of active, passive and ETF’s might be the way to go in future.
Among all your investment considerations, there is one that stands out above the rest, and that is choosing the right asset class to invest in, before you decide between active or passive funds.
The best provider of longer-term returns and management of risk is to participate in the best asset class available. If you invested in South African cash over the last twenty years, you would have received 7.01% per year; if you invested in a balanced fund, you would have received 10.54% per year; if you invested in an SA equity fund, you would have received 11.52% and in a passive TOP40 fund 12.70%. If you decided to just invest in a passive S&P500 index fund you would have received 15.10% in rand.
The lesson here is that regardless of which fund you chose, active or passive, choosing international equities as your longer-term asset class would have provided you with the best returns.
