Active investing: An opportunity for outperformance

The primary aim of an actively managed investment is to outperform the market by holding specific securities or market sectors. An actively managed fund gives you the opportunity to earn higher-than market returns; however, it also carries the risk of below-market returns. The talent of the funds manager and the cost of investment services are key in determining whether the manager can outperform the targeted index or market.

Active stock fund managers use several techniques to try to beat the market, including:

• Studying broad market trends to predict which geographic or industry sectors will prosper (the top-down approach).
• Analysing individual companies, looking for strong performance or potential thats not reflected in the current share price (the bottom-up approach).
• Using a capitalisation approach distinguished by the size of the target investment: small-, mid- or large- capitalisation companies.
• Buying the stocks of companies whose shares sell for less than their intrinsic value or whose earnings potential the market may have underestimated.
• Looking for companies with exceptional long-term growth potential.

Like stock fund managers, managers of bond funds must sift through the market to find the companies that offer the best odds of delivering positive returns. However, active bond managers must also consider other factors, such as creditworthiness and changes in interest rates.

Passive investing: Low costs and diversification

In contrast to actively managed investments, passive investments such as index funds and ETFs simply seek to match the performance of a market index at low cost.

The rationale for a low-cost passive approach is simple. Outperforming the market is extremely difficult because investing is a zero-sum game. That is, half of invested assets will outperform and the other half will underperform the market average. After costs are subtracted from investors returns, the odds of outperforming the market return become even longer.

In addition to low costs, another distinguishing feature of most passive investments is diversification. Indexing typically spreads risk widely, avoiding the losses that can follow a dramatic decline in any one specific company or industry sector. Although it spreads the risk, indexing doesnt eliminate risk. The passive approach cant protect against market declines because its goal is to follow the market (or segment of the market) as closely as possible.

Capturing the best of both worlds

Broad-market index funds and ETFs combine diversification with low costs, a strategy that has performed well relative to most actively managed funds. 1 On the other hand, active management provides an opportunity for better-than-market returns. There is a strong argument in favour of combining the two approaches.

A core-satellite strategy is one of the most common ways investors choose to combine active and passive investing. For example, you might consider supplementing the broadly diversified stock and bond index investments at a portfolios core with actively managed funds as satellites. The indexed investments at the core of the portfolio provide a risk-controlled, low-cost way to capture market returns (beta), while the actively managed satellites provide an opportunity for market outperformance (alpha).

With a combination strategy, your clients can benefit from both active and passive investing  and avoid the regret they might otherwise experience when one approach trumps the other.

1  The case for indexing in Asia (McIntosh, Thomas, 2012, The Vanguard Group, Inc.)

ETFs: A low-cost alternative

Exchange-traded funds (ETFs): A low-cost alternative

Exchange-traded funds (ETFs) are attracting ever greater attention from investors. They continue to grow globally, with assets of more than USD 1.9 trillion. 1 That trend translates to the Asia region, where ETFs have become increasingly popular. In the last five years, assets in Asia-region ETFs have almost tripled while the number of Asia-region ETFs has increased more than five-fold. 2

This guide will help you understand how ETFs work and the benefits of using ETFs in your clients’ portfolios.

What are ETFs?

An ETF is an open-ended fund quoted for trading on a securities exchange. Generally ETFs are constructed as indexed portfolios of stocks, bonds or real estate securities. Similar to individual stocks, ETFs can be bought and sold through brokerage accounts during market hours at intraday prices, rather than at end-of-day prices as with unlisted managed funds.

Like index mutual funds, ETFs offer diversification benefits and low fees, but with the added benefits of liquidity and trading flexibility of individual stocks. (See Figure 1 ).

While most mutual funds in Hong Kong are actively managed, ETFs in Hong Kong are primarily passively managed index investments. They seek to track the performance of a broad market or a specific portion of it.

The benefits of using ETFs

ETFs’ characteristics and potential benefits include:

• Low costs. ETFs generally have lower total expense ratios, or annual operating costs as a percentage of average net assets, than actively managed funds. Lower costs mean more of a fund’s returns go to the investor.
• Trading flexibility. ETFs are traded on a stock exchange, so they can be bought and sold through an adviser or a brokerage account any time the exchange is open.
• Diversification. An ETF might contain hundreds or thousands of securities, more than many actively managed funds and far more than a typical portfolio of individual securities. Diversification helps to control risk by reducing the impact of swings in performance by any one security or market segment.
• Transparency. Most ETFs hold the same securities, or a representative sample, as their benchmark indices, so you’ll always know what you’re investing in.
• Low manager risk. Index-based ETFs virtually eliminate exposure to manager risk. Thats because they seek to track, not outperform, a market index.

Buying and selling ETFs

ETFs are not traded directly with a fund management company. Instead, they are bought or sold any time during stock market trading hours directly with the exchange through a broker, adviser or brokerage account. (See Figure 2 ).

To help ensure best execution when buying or selling ETFs, consider the following:

Be aware at the open and close. At the open, not all underlying securities in an ETF may have begun trading. In such situations, the market-maker cant price the ETF with certainty, potentially causing wider bid-ask spreads. At the close, fewer firms may be making markets in the ETF and fewer shares may be listed for purchase and sale than throughout the trading day.

Consider using a block desk. When you place large orders, a block desk can break your trade into smaller increments over time to manage the impact of a large trade. Or it can create or redeem shares directly with the ETF sponsor so as not to affect prices on the secondary market. Your block desk can also review pricing depth before placing a trade.

Remember the basics. Pay attention to earnings announcements and other news from companies that are large constituents of an ETFs benchmark and to news such as the release of economic indicators. ETFs can trade at larger premiums or discounts during market swings, which such news can prompt.

As you consider ETFs for your clients’ portfolios, you can count on Vanguard’s indexing expertise and our record of putting investors first.

Comparing ETFs with mutual funds