Active vs Passive, are the risks understood?

The rise of passive investing has been a defining trend in asset management. ETFGI, an independent research and consultancy firm, estimates that global calendar year 2025 ETF flows exceeded US$2 trillion, roughly an 8% increase on 2024 numbers.

While this shift has provided investors with efficient access to market returns, passive ownership is not without risk. We look to consider this further.

Passive management is designed to replicate the performance of a market index by mirroring its composition. In doing so presents an investing alternative which seeks to outperform active strategies via lower fees and taxes through its more passive strategy.

Active management is more involved in the coalface, funds will generally aim to beat a specific market benchmark (unless stated as index agnostic).

The case for passive management is not merely anecdotal; it is built on a foundation of substantial empirical evidence that demonstrates its long term effectiveness.

The primary theoretical underpinning of passive investing is the Efficient Market Hypothesis. EMH asserts that security prices fully incorporate all available information, at all times. In essence, the object of passive investing is to fundamentally accept the average market returns.

In addition to lower costs, the widely touted advantages of passive investing are simplicity, and broader diversification. We will consider diversification shortly. But first let us consider the idea that markets are efficient.

Whether that is indeed true is for everyone to decide for themselves. If you accept that markets are not, and that skilled investors such as Warren Buffett have generated long term excess returns because inefficiencies exist, then there remains a coherent role for active management.

To be clear, numerous studies, including the widely cited S&P Indices Versus Active Scorecard, consistently show that the majority of active fund managers both Australian and US fail to outperform their benchmarks over long time horizons, after accounting for fees.

Is this simply because passive investing is a superior strategy to active management? Do lower fees entirely account for the 86% of US funds over a 10 year period underperforming their benchmark? Or is it perhaps that many active fund managers lack a genuine edge. Whilst not a direct comparison, you will find LinkedIn saturated with market commentary. Because the cost of publishing an opinion is effectively zero, while the perceived benefits such as visibility and personal branding, can be high. There is no barrier to entry and little penalty for being wrong. We think this is symptomatic of analysts today.

This is also not forgetting that there are also bad actors in markets, it is critical to remember that managing other people’s capital is a privilege.

This then creates a selection problem for investors and manger risk. Choosing an active manager requires as much discipline as selecting individual securities. Investors must assess philosophy, process, and governance.

Despite this, passive investing introduces its own set of underappreciated risks.

Let me preface this by saying, we at Moreton Financial work within active management, this discussion is a bit like asking a real estate agent if now is a good time to buy a house.

However, we feel as though we can still be impartial and see the functionality, as is evidenced, in the Moreton Financial model portfolio through instruments such as SPY and IMW. These positions reflect a deliberate choice to participate in the long run growth of US corporate earnings and innovation.

However, if you were to take ETF narratives at face value, it would suggest there is little downside. Let us examine this by better understanding how ETFs seek replicate an index.

Most equity indices, including the S&P 500 and the ASX 200, are float adjusted market cap weighted. By design, they allocate more capital to companies with larger market values and less to those with smaller market values.

This structure inevitably creates concentration risk. Concentration is not automatically wrong, sometimes the largest companies like Apple or Alphabet may warrant their size, the risk is that the index weighting can contradict the intent of diversification.

In the Australian market, the ASX 200 provides a clear illustration. Throughout 2025, Commonwealth Bank of Australia (CBA) and BHP Group (BHP) together have represented close to 20% of the index. As investors, we must question that if a small number of companies dominate a diversified benchmark, how diversified is it?

Recall that in the first half of 2023, the S&P 500’s 17% gain was driven almost entirely by the Magnificent 7, while the average stock rose only 5.6%, illustrating how headline index returns can mask narrow leadership and leave portfolio construction heavily dependent on a small number of large companies.

It is sometimes argued that thematic ETFs address the limitations of broad market indices by focusing on specific sectors or structural trends.

For illustrative purposes, consider a portfolio positioned long cyclicality through overweight exposure to materials and consumer discretionary. A defensive allocation to healthcare via a broad based ETF may appear appropriate.

However, structural concentration remains. As at 31 December 2025, the iShares Global Healthcare ETF had approximately AUD 1.46 billion in funds under management, yet its two largest holdings, Eli Lilly and Johnson and Johnson, accounted for roughly 18% of the portfolio. Despite holding more than one hundred constituents, portfolio outcomes are therefore heavily influenced by a small number of large companies.

The issue is not business quality, it is structural. Market cap weighting allocates capital without regard to valuation, balance sheet strength, return on invested capital, or management quality. As a result, business specific risks can become portfolio level risks.

Whether this is acceptable depends on the investor’s objectives.

This is exacerbated in periods of volatility or market drawdowns. If investors believe that the same earnings growth, perceived inflation stability and geopolitical risks since post COVID are likely to continue; then we agree. This is an acceptable level of risk. But we know that is not that case.

Emma Fisher, the deputy head of equities at Airlie Funds Management, recently wrote a great reflection piece for Rampart on the state of the Aussie market in review of 2025. And we believe the below exert illustrates this point perfectly.

Information Ratio = Information Coefficient multiplied by the square root of Breadth.

The law suggests that a manager’s success (Information Ratio) is the product of two key variables: Skill (Information Coefficient) and Breadth (the number of independent opportunities).

In short, excess returns are only achievable if a manager has both skill and sufficient opportunity to apply that skill repeatedly.

This framework directly informs how we think about deploying capital as investors.

As we try to illustrate via the Moreton Financial Model Portfolio, risk is concentrated where we believe mispricing is most likely; either in less efficient geographies, in complex or cyclical sectors, and or under researched parts of the capital structure. This is then offset by understanding we are not active everywhere, but are intentional in where we choose to differ from the benchmark.

The model portfolio seeks to educate that our active positions therefore are not expressions of market timing, but deliberate attempts to apply fundamental judgement where passive construction falls down.

In our opinion passive and active investing are not mutually exclusive philosophies. Both can coexist, yet it is determinant on the ability of active managers. Passive exposure enhances active management. Active exposure is reserved for areas where mispricing exists and where the Fundamental Law suggests that a disciplined approach can realistically add value over time.

It is still early days for Moreton Financial, but in the words of Tolstoy; the two most powerful warriors are patience and time.

“Unprofitable companies are flying, up 40 per cent in the last six months, low returning businesses are dramatically outperforming high returning businesses, and companies with the highest leverage are outperforming companies with the lowest leverage.

For evidence that we are in broken coin territory, we need look no further than the rise of Australian banks. If you added together the underlying cash earnings per share produced by the Big Four in financial 2023, it amounted to $13. In FY25, that figure is $12.43, a four per cent decline.

Yet if you add together the share prices of the Big Four, you would have paid $178 for those earnings two years ago versus $264 today, a 48 per cent increase.”

The Big Four weights of the iShares Core S&P,ASX 200 ETF as of 31/12/25 were CBA 10.11%, Westpac 4.9%, NAB 4.88%, ANZ 4.08%. That is 24.04% of the ETF! We would not call that diversified.

We also feel that sector and industry structure is another important source of inefficiency and not effectively capture via index investing. Industries characterised by complexity, cyclicality, or high operating leverage often experience earnings volatility, which can dominate market narratives and drive mispricing. Capital intensive industrials, energy and resource producers, and other commodity linked businesses are typical examples. In these areas, passive allocations can systematically underweight smaller companies with improving fundamentals, simply because market capitalisation has not yet adjusted.

Let us return to active management. As we have mentioned, a passive investor is explicitly choosing to earn an average market return.

The case for active management does not rest on the claim that most active managers outperform. It rests on the belief that markets are not perfectly efficient, and that skilled investors can exploit mispricing.

We must reiterate the statistical reality of active management. Higher fees are a primary and persistent headwind. The additional expense of an active fund creates a performance hurdle that a manager must clear just to match the index.

We previously noted however that there remains a role for active managers and for research driven insights. The caveat is that this role exists when active risk is applied selectively and with discipline.

Less efficient markets provide one such opportunity set. One area is the broader Asia ex‑Japan region, including South East Asia and China. We currently see particular opportunity in consumer facing industries. These economies combine a large growing middle class, and an evolving regulatory landscape.

We are maintaining a close watch on this opportunity set and are evaluating how we might explore an exposure for illustration purposes in the Moreton Financial Model Portfolio.

Consider also that U.S large cap markets currently have an average of 30 analysts covering each company, U.S small cap and emerging markets, will often have as few as 6 analysts per stock.

In these environments we see that an active manager has a greater chance of identifying mispricing.

Active management only adds value when the underlying analysis is proven correct. When it is, returns can be asymmetric because capital is allocated deliberately.

This is where the Fundamental Law of Active Management provides a useful organising framework. The law is expressed as: