There are many different theories, philosophies and approaches to share investment. One of the most basic decisions is whether to take an active or a passive approach.
Passive fund managers believe that, over the long term, it is impossible to out-perform the share market as a whole. It therefore makes no sense to spend large amounts of money on expensive analysts, and passive managers simply try to match the index performance.

Active managers believe that, with careful stock selection and by timing their sales and purchases, they can out-perform the market. In Australia active managers have, on average, produced better headline returns than passive managers. However, before jumping on the active bandwagon, we need to delve a little deeper.

Funds performance is usually reported on a pre-tax basis. This is because most funds do not pay tax. All of the income and realised capital gains are distributed, and taxed in the hands of the unit holders.

Passive fund managers have little need to buy and sell shares, as their portfolios simply reflect market make-up. Therefore, their distributions should contain little in the way of realised capital gains, and because of their lower costs, passive funds can also charge lower fees.

On the other hand, active fund managers are buying and selling shares constantly. A high turnover of the portfolio leads to a high level of realised capital gains, and it is the tax on these distributions that can sour the active investing experience.

For example, let’s compare a passive fund that doesn’t realise any capital gains with an active fund that turns over its whole portfolio each year. If the passive fund consistently produces a return of 5% income and 10% capital growth, and taking into account the difference in fees, the active fund would need to generate capital growth of 19.3% per annum to deliver the same after-tax return to an investor on the top marginal tax rate. This requires out-performance of a staggering 9.3% per annum, year in, year out! That’s quite a challenge!

This may be an extreme example. The lower the portfolio turnover and the lower the investor’s marginal tax rate, the lower the hurdle of excess returns.
It can be difficult to find out the actual level of portfolio turnover for a fund, but one indication of high turnover is that distributions contain a high proportion of realised capital gains. Unit holders will find this information on their annual tax statements, and some managers publish details in their fund profiles.

This isn’t to argue that active management should be ignored. However, investors do need to look beyond the headline performance figures reported by fund managers, and consider the tax implications of the management style in relation to their individual circumstances. If in doubt, always speak to a financial professional first.