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Key Differences Between Passive EFT’s and Active Fund Managers

Passive Exchange-Traded Funds (ETFs) and actively managed funds are two of the most popular investment vehicles today. Both provide investors with opportunities to diversify their portfolios, but they operate in distinctly different ways.

1. Investment Strategy

The most fundamental difference between passive ETFs and actively managed funds lies in their investment strategy.

Passive ETFs:
A passive ETF is designed to replicate the performance of a specific market index, such as the ASX 200 or the S&P 500. These funds are passively managed, meaning they do not attempt to outperform the market or make individual investment decisions. The ETF simply tracks the index by holding the same securities in the same proportions. For example, an ASX 200 ETF holds all 200 stocks of the index in the same weightings as the index itself.

The goal of passive ETFs is to match the performance of the underlying index as closely as possible. This strategy assumes that, over the long term, the market will grow at a steady rate, and attempting to beat the market is futile or too costly.

Active Fund Managers:
In contrast, active fund managers aim to outperform the market or a bench mark index. They conduct research, use their expertise, and make decisions about which securities to buy, sell, or hold. Active managers may focus on individual stock selection, market timing, and macroeconomic trends to make investment decisions that they believe will provide higher returns than the market or index.

Active managers are constantly adjusting their portfolios based on their analysis, seeking to take advantage of short-term opportunities or long-term trends. The objective is to outperform a benchmark, such as the ASX 200 or any other relevant index.

2. Costs

One of the most significant differences between passive ETFs and active funds is cost.

Passive ETFs:
Because passive ETFs simply track an index and do not require significant research or decision-making, they tend to have lower management fees. The expense ratio of passive ETFs is typically low, often in the range of 0.05% to 0.25% per year.

Active Fund Managers:
Active funds tend to have higher costs due to the active management required.  Fund managers must employ research analysts, make frequent trading decisions, and often use sophisticated investment strategies, all of which contribute to higher fees. The expense ratio for actively managed funds can range from 0.50% to over 2.00%, depending on the fund.

3. Performance Expectations

The performance expectations of passive ETFs and active funds differ significantly.

Passive ETFs:
Since passive ETFs are designed to mirror the performance of an index, their returns are generally in line with the market, minus any fees. Investors in passive ETFs should expect market-average returns over the long term. Investors who are content with “average” returns, in exchange for lower risk and fees, may prefer this approach.

Active Fund Managers:
Active fund managers, on the other hand, are trying to beat the market or outperform a specific benchmark index. The success of active management depends on the skill and insight of the fund manager.  If the manager is successful, the fund could outperform the market, providing higher returns. However, the opposite is also true—if the manager makes poor decisions, the fund may underperform.

4. Risk and Volatility

Passive ETFs:
Passive ETFs generally offer a lower level of risk compared to actively managed funds because they follow an established index. Since they are designed to replicate the performance of an index, passive ETFs tend to be more diversified, spreading risk across many stocks or bonds in the index. This broad diversification reduces the risk of any individual stock significantly impacting the overall performance.

However, passive ETFs are still subject to market risk. If the entire index declines, so will the passive ETF.

Active Fund Managers:
Active funds, by contrast, are often more concentrated in specific sectors, industries, or types of assets, depending on the manager's strategy. This can lead to higher risk if the fund’s holdings underperform. Active managers can mitigate this risk by diversifying and adjusting the portfolio in response to market conditions. However, this increased level of flexibility also means that active funds can be more volatile in comparison to passive ETFs.

Active managers can also use strategies to hedge against risk or seek opportunities that may provide higher returns, but they cannot eliminate risk entirely.

5. Tax Efficiency

Passive ETFs:

Since passive ETFs generally have lower turnover(they buy and sell fewer securities), they realize fewer capital gains. With lower turnover, passive ETFs can help investors avoid paying unnecessary taxes on capital gains.

Active Fund Managers:
Active funds tend to have higher turnover because managers frequently buy and sell securities. This higher turnover can lead to more taxable events.

Conclusion

The key differences between passive ETFs and active fund managers centre on their investment strategies, costs, performance expectations, and levels of risk. Passive ETFs provide a low-cost, diversified, and tax-efficient way to invest, with returns that closely mirror the performance of a market index. Active fund managers, on the other hand, offer the potential for higher returns through skilful decision-making, but they come with higher fees, greater risk.

By Brendan Irwin

SQM Senior Research Analyst

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Please see below for descriptions of each star rating, whose purpose is to act as a guide for dealer group research teams and investment committee:

4.5 stars and above - Outstanding. Highly suitable for inclusion on APLs.
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4 stars - Superior. Suitable for inclusion on most APLs.
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The rating contained in this document is issued by SQM Research Pty Ltd ABN 93 122 592 036 AFSL 421913. SQM Research is an investment research firm that undertakes research on investment products exclusively for its wholesale clients, utilising a proprietary review and star rating system. The SQM Research star rating system is of a general nature and does not take into account the particular circumstances or needs of any specific person. The rating may be subject to change at any time. Only licensed financial advisers may use the SQM Research star rating system in determining whether an investment is appropriate to a person’s particular circumstances or needs. You should read the product disclosure statement and consult a licensed financial adviser before making an investment decision in relation to this investment product. SQM Research receives a fee from the Fund Manager for the research and rating of the managed investment scheme.