Active and Passive Asset Management - A NZ Equity Perspective
11 Oct 2001 09:25
Portfolio management can be broadly categorised into active and passive management styles.
Passive Portfolio Management
Passive portfolio management has two facets – where a manager adopts a long-term buy and hold strategy or an index replication strategy. Index replication is where a portfolio manager chooses individual securities designed to track a specific benchmark or index. The most common index replicated in New Zealand is the NZSE40 Index.
Active Portfolio Management
Active portfolio management is a method of choosing securities with the goal of outperforming a benchmark or index. Within active management there is a spectrum of aggressive and conservative styles. A conservative manager may track the index, attempting to add value by taking small bets around the index. While an aggressive manager will typically give little regard to index holdings and weightings. The performances of an aggressive manager can deviate substantially from that of the index.
An active management style often requires analysts and other investment professionals to research companies. Due to the additional resources required, “active” funds typically have higher annual management fees. These fees typically range from 0.6% to 1.0% for passive funds and from 1.0% to 2.0% for active funds.
Tax Treatment of Capital Gains
In July 1996 the New Zealand Inland Revenue Department (IRD) allowed the NZSE TeNZ Fund a tax exemption on capital gains. Since this exemption several other passive funds have also gained a similar binding ruling from the IRD. Passive portfolio managers argued that they were not in the “business” of buying and selling shares, thus they should not be subject to capital gains tax.
Passive funds do have a tax advantage, although this is limited by investing in New Zealand shares. This is because capital growth is usually sacrificed for fully or partially imputed dividends.
Supporters of passive portfolio management argue that markets are efficient and that active managers can not consistently outperform. These supporters also state that lower fees coupled with the tax advantage, mean that index funds are in the long run, better investment vehicles. Therefore, active managers must consistently outperform the index by at least 1% to justify their existence and fees.
FundSource compiles performances for 18 active and eight passive New Zealand equity unit trusts and GIF’s. The following graph shows the average annualised performances as at August 2001 for the 18 active and eight passive funds over the last three years. Unfortunately the comparison could not be extended as only one of the eight passive funds has a five-year history.
The average three-year annualised performance for active managers’ is 10.9%, which is 4.1% higher than that recorded by passive managers. This discrepancy is largely attributable to some of the passive funds tracking the poorer performing NZSE10 Index. The passive NZ Midcap Index Fund was benchmarked against an index that recorded a three-year annualised return of 20.4%. This outlying result would have somewhat skewed the passive average.
The active three-year annualised return is 3.7% higher than the NZSE40 Index performance. This reflects that on average, active managers can outperform the market on a consistent basis, post tax and fees. The problem that arises is that it is impractical for an investor to hold all 18 active funds. At this point, an investor or financial advisor has to select funds, which they believe will outperform the index. Financial advisors typically rely on professional research, such as that produced by FundSource. FundSource’s research and qualitative analysis aims to identify managers who have the fundamentals in place to outperform.
The 24 managed funds included in the above analysis have a total fund size of over $900 million of which approximately 13% is passively managed. Active managers, on average, have added value over the last three years. However, three of the 18 active managers failed to better the index’s three-year annualised performance of 7.2%.