February 2025

Choosing truly active funds to enhance portfolio returns.

Are enough active funds genuinely active? That’s becoming a more important question for financial advisers and investors who blend active and passive strategies in portfolios.

Released in June, Adviser Ratings’ Australian Financial Advice Landscape 2024 report found advisers are increasingly adopting a mix of active and passive strategies. 

Advisers are using active funds as portfolio ‘satellites’ to potentially add value. This raises the bar for active funds, which must deliver true alpha (returns beyond the market) to justify higher fees.

Concerns with ‘closet indexing’

Not all funds labelled as active, however, are genuinely so. Some closely follow their benchmark, resulting in performance similar to passive funds despite charging higher fees. Others rely on momentum strategies, often investing in popular but overvalued stocks. These strategies can lead to frequent portfolio turnover, creating adverse tax consequences and diluting the potential for excess returns.

This lack of differentiation undermines the effectiveness of active funds in portfolio construction, as funds that mimic indexes fail to diversify risk or enhance returns. To add true value, active funds must be distinct and avoid ‘closet indexing’.

Value of genuine active management

Funds charging premium fees for active management should prove their worth with unique stock and sector weightings that set them apart from the market. The pressure is on active funds to offer differentiated returns through genuinely active management.

A 2019 study by Panchekha highlights the importance of high-conviction positions for active managers. It found that high-conviction overweight positions — where managers back their best ideas — generated positive alpha relative to benchmarks. However, some active managers dilute their potential returns by including too many neutral or underweight positions, closely mirroring the index and diminishing the impact of their top picks.

For advisers, this finding emphasises the need to select active funds that focus on high-conviction positions. Funds that take concentrated, high-conviction bets are more likely to outperform, though they may come with higher volatility. Over time, high-conviction approaches, especially in portfolios designed for the long term, can lead to stronger returns, provided that investors are patient through market cycles.

Evaluating genuinely active funds

Several metrics can help advisers identify genuinely active funds. Tracking error, a measure of volatility in returns relative to a benchmark, indicates how much a fund deviates from its index. Higher tracking error generally signals more active management, although it doesn’t guarantee positive alpha.

Holdings-based style analysis, which compares a fund’s holdings to its benchmark, offers further insight. Funds with fewer overlapping stocks with the index are likely to be more actively managed. For example, PM Capital’s Global Companies Fund has a distinctive sector allocation, with a 40% exposure to Financial Services versus 16% in the MSCI World Net Total Return Index (AUD) as of 31 October 2024¹. The Fund also has no exposure to technology stocks, which make up 25% of the benchmark, further highlighting its active strategy.

A distinct approach is also evident in the Fund’s geographic allocations. At end-October 2024, the Fund held significantly more European stocks and fewer US stocks compared to some of its peers, reflecting its unique perspective. Such differentiation has contributed to its outperformance, with the Fund ranking in the top percentile of its Morningstar category in September 2024².

Portfolio turnover can also indicate a fund’s conviction level. PM Capital’s Global Companies Fund, for example, reported an 3-year turnover of 20% at end-September 2024, indicating a buy-and-hold strategy. Lower turnover suggests the fund is focused on long-term growth rather than chasing short-term gains.

Case for high-conviction active funds

For investors and advisers, high-conviction active funds can be a valuable complement to passive portfolios. By focusing on select investments with high potential, these funds differentiate themselves from index-based approaches. PM Capital’s high-conviction approach, for instance, is designed to perform differently from benchmarks with the aim to deliver long-term outperformance.

Ultimately, selecting active funds that align with genuine active management principles has the potential to enhance portfolio performance. High-conviction, low-overlap strategies with distinct sector and geographic allocations can help active funds justify their place in increasingly passive-oriented portfolios, providing the potential for enhanced returns in the long run. 

To learn more about active fund strategies, visit www.pmcapital.com.au/insights.

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Sources

Adviser Ratings (2024) “Australian Financial Advice Landscape 2024”. June 2024

Panchekha, A (2019) “The Active Management Paradox: High Conviction Overweight Positions”. Enterprising Investor. CFA Institute. October 2019.

Disclaimer

This insight is issued by PM Capital Limited ABN 69 083 644 731 AFSL 230222 as responsible entity and issuer of the PM Capital Global Companies Fund (ARSN 092 434 618). It contains summary information only to provide an insight into how we make our investment decisions. This information does not constitute advice or a recommendation, and is subject to change without notice. It does not take into account the objectives, financial situation or needs of any investor which should be considered before investing. Investors should consider the Target Market Determination and the current Product Disclosure Statement (which are available here pmcapital.com.au/steps-investing), and obtain their own financial advice, prior to making an investment. Past performance is not a reliable indicator of future performance and the capital and income of any investment may go down as well as up.

¹MSCI World Index (AUD) Index Factsheet, as at 31 October 2024. ² Refers to performance of PM Capital's Global Companies Fund, which has been ranked in the top five funds in its category over three, five, seven, 10 years and since inception in 1998, to 30 September 2024. Source Morningstar. Peer group ranking source: Morningstar Direct. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information on the Morningstar website. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information.