KEY POINTS:
The debate between supporters of active and passive management is one of the most contentious among investors.
The vast majority adopt the active approach but some influential commentators, including Mary Holm of the Weekend Herald, are strong supporters of the passive method.
What is the difference between active and passive management and why do most investors adopt the active style?
In active management fund managers and investors build portfolios with the clear objective of maximising returns and outperforming the sharemarket average.
A conservative investor may take into account a sharemarket index when constructing a portfolio but an aggressive investor will give little regard to index holdings or weightings.
Active investors, particularly fund managers, will also take a full role in a company's affairs by voting at annual meetings, taking a keen interest in the way the company is run and supporting or opposing takeover offers or mergers.
Investment managers have had a major role in opposing takeover offers and merger proposals for Contact Energy that were well below the group's current market price.
In passive investment, portfolios are constructed to exactly mirror the holdings and weightings of companies included in a particular sharemarket index.
Investors make no attempt to pick individual stocks; they are happy to accept the returns generated by the index they choose to mirror.
In New Zealand passive funds have had a big tax advantage because they are exempt from tax on their capital gains.
The capital gains tax on active funds will be removed this year, which will place them on an equal footing with their passive competitors.
Passive funds are not allowed to vote at annual meetings, take an active interest in governance or strategic issues or support or oppose takeover offers or mergers.
They can buy or sell shares only when a company is introduced or removed from an index or its weighting is increased or decreased.
Supporters of the passive style say more than half of fund managers under-perform the market average and charge too much in fees.
This argument is difficult to justify, particularly in New Zealand.
FundSource, the investment research organisation, says the five passive New Zealand equity funds it covers had an average return of 16 per cent for the year to November 30, 2006, compared with an average return of 18.7 per cent for the 10 active NZ funds it covers (figures for the year to December are not yet available).
The performance of the passive funds was even worse on a weighted basis, because the largest passive fund had a return of only 4.8 per cent whereas the biggest active fund returned 39.4 per cent.
The same results applied over a three-year period.
Passive funds had an average annualised return of 14 per cent and active funds had an average return of 14.5 per cent.
All these figures are after tax and the deduction of management fees.
The performance of passive funds is even worse when it is considered that they are exempt from capital gains tax whereas active funds are subject to a 33 per cent tax on all capital gains.
Why do some commentators argue in favour of passive funds when there is clear evidence that they have underperformed active funds despite having a huge tax advantage?
The only conclusion is that they are using overseas data and arguments and applying these incorrectly to New Zealand.
A passive approach can be justified outside Australasia - and in a long bear market in New Zealand - but there is no evidence that investors should prefer passive over active in the domestic market.
The other problem with passive funds is that it is just as important to choose the best-performing fund as it is to choose the best performing companies in an active portfolio.
Five main Australasian passive funds are listed on the NZX.
These funds, all run by NZX's Smartshares division, are:
* Fonz, which tracks the performance of the NZX 50 portfolio Index.
* Midz, which is aligned to the NZX midcap index.
* Tenz, which tracks the NZX 10 index - 10 of the largest listed New Zealand companies.
* Mozy, which is aligned to the Australian S&P/ASX midcap 50 index. * Ozzy, which is aligned to the companies in the Australian S&P/ASX 20 index.
As the table shows, the performance of the three main listed New Zealand-oriented passives - Fonz, Midz and Tenz - varied widely last year.
Tenz, the largest New Zealand- oriented passive fund, had a return of 9.8 per cent compared with 32.5 per cent for Fonz and 43 per cent for Midz.
These figures, which are compiled by the NZX, are calculated on unit price movements, assuming distributions are reinvested and are after tax but before management fees.
In comparison, the NZX 50 gross index returned 20.3 per cent last year.
These figures clearly indicate that passive investors have to make an active decision before committing to an index-based fund.
Is it any easier to pick the best-performing passive funds than it is to choose the best performing companies?
What will be the best performing New Zealand-oriented passive fund this year and how will it compete with active funds when their huge tax disadvantage is removed?
The New Zealand Superannuation Fund is an excellent example of the advantages of taking an active approach towards portfolio management.
In the year to last June, the Superfund's total equity portfolio outperformed its benchmark indices by 3.5 per cent after fees (28.3 per cent compared with 24.8 per cent).
In the same 12-month period, the fund's New Zealand equity portfolio had a return of 23.9 per cent after fees compared with the NZX 50 return of 16.8 per cent.
This gave it an excess return of 7.1 per cent over its benchmark index from an active management approach to New Zealand equities.
Finally, it is hard to believe there is strong support for a management style that takes a totally docile attitude towards corporate governance.
This includes abstaining from voting at all company meetings, either by proxy or in person.
New Zealand needs more, rather than fewer, active investment managers in an era when corporate governance issues need to be vigorously monitored.
The NZX also needs fund managers who aggressively oppose low-priced takeover offers from private equity interests and large overseas companies.
It can be argued that the widespread opposition to offers for Contact Energy has added considerable wealth for New Zealand investors, including passive funds.
New Zealand investors would also be far better off today if there had been more opposition to the sale of large banks and media organisations.
Passive fund investors are charged low fees, but the funds performance is behind that of active funds on an average returns basis.
These funds also make no contribution to corporate governance issues and rely on others to look after their interests in this area.
