Over the last fifteen or so years, trillions of dollars have poured into investment funds which passively track indexes such as the S&P 500 or the NZX 50. An index fund matches the components of a particular index and its performance will therefore match the performance of the index. The main selling point for index funds is they offer investment diversification with low management fees. In comparison, actively managed funds attempt to out-perform an index by using research to pick investments that may produce a higher return. The cost of this research adds to the fund management fee. Active fund managers argue that the higher performance of their funds more than offsets the higher management fees, however analysis shows that this is true for a minority of actively managed funds.
The stellar growth of passive funds has seen the development of an array of funds which invest in specific assets classes. If there is a niche market you want to invest in – such as healthcare or energy – there is probably a passive fund to match. This makes investing easy for the DIY investor. Passive funds do away with the need for stock-picking. The challenge becomes one of getting the right mix of asset classes in a portfolio rather than the picking individual investments. Hence the development of actively managed passive portfolios, where the underlying investments are passive funds and the active management is applied to choosing the asset allocation – that is, the mix of funds in the portfolio.
This development is both a threat and an opportunity for financial advisers who make a living out of stock selection and customised portfolios. If the research is correct – that is, if stock-picking mostly can’t beat an index – then the art of portfolio management needs to shift towards managing the asset allocation.