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

Passively managed funds have become increasingly popular over the years due to their lower fees compared to actively managed funds.

Exchange-traded funds (ETFs) have made it easier than ever to buy and sell passively managed indexes, and a growing number of investors are starting to question the performance of actively managed funds. On the other hand, many active managers insist that their strategies can help reduce portfolio risk and potentially generate higher returns, which both could improve the risk-adjusted returns.

The most important factor for investors deciding between active and passive funds is risk-adjusted excess returns compared to 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 or lower the risk with the same returns to achieve better performance.

At the same time, international investments may have more opportunities for active fund managers to generate excess risk-adjusted returns.

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 of 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, 74.10% of large-cap funds underperformed the S&P 500 index over the 5-year period, and over a ten-year period, large-cap funds underperformed the S&P 500 by 83.07%.

Choosing Between Them

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