Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 66

Active versus passive – what about risk?

The core focus of the active versus passive management debate is an analysis of the value added after fees by active managers compared to a benchmark. Noting that you can't invest in a benchmark, passive investment options are used, for example an index fund or ETF, that aim to replicate benchmark returns for a fee.

Considering this, an analysis of active versus passive approaches should focus on the relative returns of the two alternatives, not of the benchmark per se. This analysis should also include issues such as risk and tax.

The purpose of this discussion is to consider the issue of risk.

Risk can be defined many ways, and few people seem to share a common understanding of it. From an active management perspective, risk is often considered on a relative basis. For example, the risk that an investment may perform poorly compared to an index fund or ETF.

A simple framework for retail investors to understand risk

Risk management is a dimension of active management not often discussed, especially with retail investors, due to its perceived complexity. However, the following is an outline of a simple, integrated approach to determine whether investment risks are:

  • recognised and understood
  • rational and taken on intentionally, and
  • rewarded (every risk should have a commensurate long-term reward potential).

To illustrate this framework, let’s look at the Global Fixed Income sector and why it may not make sense from a risk perspective alone to invest in an investment approach that aims to replicate the benchmark.

The Global Aggregate Bond Index is the most widely followed bond index in the world and is the major benchmark against which global bond managers are measured. Unlike equity benchmarks where the more successful and profitable a company is, the more it grows in size and the larger its weighting in the benchmark becomes, global bond indices could be said to work in reverse.

The largest constituents of the Global Aggregate Bond Index are those countries or regions that issue the most debt: the United States, Japan and the Euro. It could also be argued that they are among the least sound long term financial credits, partly based on the amount of outstanding debt they have on issue. In this case does it make sense to follow the benchmark via an index strategy just because it can be accessed cheaply?

What are the risks of investing in this benchmark approach? Using the framework above, we can identify the risks:

  1. Is the risk recognised by investors? At a retail investor level, the answer is likely to be no. Many investors are unlikely to be aware of the composition of the benchmark, and in particular its significant concentration risk. In the Global Aggregate Benchmark, the top three issuers represent over 90% of the benchmark.
  2. Is the risk rational? Diversification is one of the basic strategies for reducing risk. A compelling case could be made that the majority of investors would not intend to invest 90% of a portfolio in just three issuers. The significant growth of absolute return fixed income strategies and the shift away from benchmark-aware global fixed income strategies supports this.
  3. Is the risk rewarded? In the current environment, yields on ten-year US treasuries are 2.6% and on Japanese bonds 0.6%. That is, an investor lends the US and Japanese governments money for ten years and receives just 2.6% or 0.6% return. It would not appear that the risk is being rewarded. Add to this the widely held view that after a 30-year bull market in bonds, the only way is up for bond yields, and the potential loss of capital value for those currently holding bonds becomes significant, so there’s even less appeal to invest in either absolute or relative fixed income options.

Investor expectations of performance

In looking at risk from an active management perspective, ineffective risk management becomes evident in the gap between investor expectations of performance relative to a benchmark and actual performance. An active manager might be happy to outperform an index by a margin, even if delivering negative returns to the investor. We don’t need to look too far back (2008) to see that ineffective risk management can lead to disappointment. There are a number of examples from that period where underestimating the risks of Collateralized Debt Obligations (CDO’s) or municipal bonds left many investors in active strategies suffering significant losses in both absolute and relative terms. In these instances the risks were not recognised, rational or rewarded.

The purpose here is not to dismiss the case for active or passive approaches as there are roles for both, but rather to broaden the discussion to include risk as a necessary and integral part of any active versus passive debate, especially for retail investors.

 

Jim McKay is Director of Advisory Services at Franklin Templeton Investments.

 


 

Leave a Comment:

RELATED ARTICLES

Track if your fund manager is taking the best shot

The difficulties picking fund manager winners

Why good active managers should outperform

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

Latest Updates

Investment strategies

9 winning investment strategies

There are many ways to invest in stocks, but some strategies are more effective than others. Here are nine tried and tested investment approaches - choosing one of these can improve your chances of reaching your financial goals.

Planning

Super, death and taxes – time to rethink your estate plans?

The $3 million super tax has many rethinking their super strategies, especially issues of wealth transfer on death. This reviews the taxes on super benefits and offers investment alternatives.

Taxation

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

Shares

The megatrend you simply cannot ignore

Markets are reassessing the impact of AI, with initial euphoria giving way to growing scepticism. This shift is evident in the performance of ASX-listed AI beneficiaries, creating potential opportunities.

Gold

Is this the real reason for gold's surge past $3,000?

Concerns over the US fiscal position seem to have overtaken geopolitics and interest rates as the biggest tailwind for gold prices. Even if a debt crisis doesn't seem likely, there could be more support on the way.

Exchange traded products

Is now the time to invest in small caps?

With further RBA rate cuts forecast this year, small caps may be key beneficiaries. There are quality small cap LICs and LITs trading at discounts to net assets, offering opportunities for astute investors.

Strategy

Welcome to the grey war

Forget speculation about a future US-China conflict - it's already happening. Through cyberwarfare and propaganda, China is waging a grey war designed to weaken democracies without firing a single shot.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.