Passive vs. Active: What Type of International Funds Should You Buy?

A Look at the Differences Between Active and Passive Funds

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Passively managed funds have become increasingly popular over the years. Exchange-traded funds (ETFs) have made it easier than ever to buy and sell indexes and a growing number of investors are starting to question the performance of actively managed funds. On the other hand, many active managers regularly outperform benchmark indexes and generate significantly greater excess returns than passive strategies.

The most important factor for investors deciding between active and passive funds is risk-adjusted excess returns from a benchmark index. By definition, passive funds match market returns by investing in a broad basket of assets whereas active fund managers must find ways to outperform the market by exploiting market inefficiencies. International investments may have more of these inefficiencies for active fund managers to exploit. In this article, we’ll take a look at whether international investors should focus on passive funds, active funds, or both types of funds.

Local Knowledge Matters

International investing is significantly more complicated than domestic investing, with a combination of political, liquidity, and currency risks. These factors can create more inefficiencies within individual stocks than domestic markets. Active managers can maneuver a portfolio to take advantage of these inefficiencies by hedging these risks in order to reduce a portfolio’s overall risks and enhance its risk-adjusted return.

For example, suppose that an investor has a choice between a country ETF that invests broadly across asset classes or an actively managed fund focused on that country. A fund manager may notice that politicians in the country are seeking to nationalize energy industry assets and decide to sell off those assets to mitigate the risks.

By comparison, an index fund would be forced to continue holding those assets and risk the nationalization destroying value.

Active managers with local knowledge can help predict these kinds of risks better than the average investor. These advantages can become even more acute in frontier markets and emerging markets where the risks are more uncertain and liquidity is lower. While the efficient market hypothesis may hold in the United States, the lack of knowledgeable investors may make some markets far less efficient, which creates opportunities for active managers.

A Hands-Off Approach

Passive funds assume that markets are efficient and focus on mitigating controllable influences on total returns – such as fees and turnover. In other words, they assume that if an energy industry were at risk of nationalizing, investors would have already lowered the valuations on these companies to account for the risks. This is generally considered to be the case, which is why most active managers fail to outperform their benchmark indexes each year.

In the previous example, it’s possible that the market would have already discounted the prices of energy companies before the active fund manager reduced exposure.

The passive fund may have outperformed the active fund in that case, since the active fund incurred more transaction fees and likely charges a higher expense ratio. These passive funds also avoid crowd psychology and other potential pitfalls that could drive active managers to make the wrong decisions.

According to S&P Indices Versus Active (SPIVA) scorecard, 87% of large cap active fund managers outperformed the S&P 500 index over the 5-year period leading up to 2015 and 82% failed to deliver incremental returns over the decade leading up to that point. Meanwhile, the average expense ratio of actively managed funds was 1.23% compared to just 0.91% for passively managed funds, which can have a big impact on overall returns.

Choosing Between Them

Most investors are better off with passively managed funds, since they will realize market returns with little to no effort.

In general, investors should seek out highly liquid and low-cost ETFs or indexed mutual funds that target broad geographic areas in order to maximize their diversification and risk-adjusted returns over time.

When looking at active funds, investors should carefully analyze active managers before investing. A better alpha on the surface could be coming from a poor choice for a benchmark – making it easy to beat – or excessive risk taking. It’s also important to take a look at the expenses being charged by these fund managers to ensure that it’s not too high to overcome with excess returns when compared to a passive fund.

Key Takeaway Points

  • Passively managed funds have grown in popularity over the years, as investors have moved into ETFs and shunned high-fee active mutual funds.
  • Active managers may be able to outperform their benchmark indexes when there is a lot of inefficiency in the market, as occurs in many illiquid frontier markets.
  • Passive funds tend to perform best in most markets – even international ones – since the market is generally pretty efficient at adjusting prices.
  • Most investors should stick to passive funds, although active funds may be worth considering in inefficient markets, if they’re willing to put in the research.