Active and Passive – There’s Room for Both

The passive-versus-active debate in investing remains a lively one, some two decades after the emergence and subsequent surge in popularity of index-tracking funds. While compelling arguments continue to be made on both sides, most investment and financial planning experts agree that there is room for both active and passive strategies in a well-rounded investment portfolio.

As a brief refresher, active funds are run by managers who actively choose which securities to buy and in what quantities, and then decide when to sell. A manager’s investment strategy may impose parameters or conditions under which securities may be bought and sold, but within those parameters the composition of an investment portfolio is decided on a mixture of research, analysis and investment acumen.

The composition of a passive fund, on the other hand, is determined by a market index or, in the case of a multi-asset fund, an index per asset class. The manager simply ensures that the holdings of the fund replicate the holdings of the index.

While active funds can outperform an index through adept management, they often fall short. Passive funds perform in line with the index they track (less fees, which are generally lower than active funds), not better and not worse, never forgetting that the index itself can perform poorly.

The argument for passive investing is that, for a lower investment fee you get the performance of the index and that, over longer periods at least, the average active manager underperforms the index. Active managers argue that this is an oversimplification. They measure their performance against a fund benchmark, which may not correspond to the index used for the comparison. Also, comparing straight performance does not take into account investment risk, which active managers typically attempt to navigate.

Active/Passive Barometer

While it may not provide a complete picture, a new means of comparison has been introduced by Morningstar Investment Management South Africa: its Active/Passive Barometer rates how active funds have performed relative to their passive peers across a range of categories. The report provides insights into where active managers are delivering value and where lower-cost passive strategies remain difficult to beat.

Key findings from the 2024 report include:

• Active South African equity funds registered a success rate of 83.6% against a comparable passive fund composite in 2024 – in other words, over four-fifths of active managers outperformed their passive peers during the year. Strong performance from the mid- and small-cap parts of the local market in 2024 provided opportunities for active managers to add value. However, over longer time horizons the success rate of active funds drops dramatically – over 10 years only 25.5% of active SA equity funds delivered returns above those of the average passive fund in their categories.

• Globally, active equity funds continue to underperform against passive funds. In Mornbingstar’s global large-cap equity category only 13.8% of active funds outperformed in 2024, and only 3.9% did so over 10 years. In the global emerging markets category, outcomes were slightly better – 20.1% of active funds beat their passive rivals over 10 years.

• Some asset classes appear more suited to active management. Active South African diversified bond funds (which we know as SA Interest Bearing Flexible funds) saw a success rate of 55.2% over one year and 59.5% over five years. In the South African listed property category (SA Real Estate General), 60.5% of active funds outperformed passive peers over 10 years, although 2024 was a more difficult year for the category, with just one-third of active funds outperforming.

Michael Dodd, senior fund analyst at Morningstar Investment Management SA, says that, globally, investors have increasingly shifted from active to low-cost passive strategies. However, South Africa has lagged this trend. “Active investing still plays a prominent role locally, largely due to differences in market structure and development,” he says.

Dodd believes that both active and passive strategies have a role to play in building well-diversified, cost-effective investor portfolios. He says: “Our research shows that low-cost investing is a sure-fire way to improve outcomes, but there are also times when it can be justified to pay for active management. This report aids us in understanding key trends that help inform investment selection when building portfolios.”

The full Morningstar South African Active/Passive Barometer is available for download here.