When you pay someone to manage your money, the promise of ‘active management’ can be reassuring. It assumes a level of insight and expertise not available to the amateur investor.
But active management is not the only option, and sometimes a passive strategy can meet your requirements equally well, and at a lower cost.
Active Investing
An active investment strategy aims to beat the benchmarks with the application of data, analysis, and human judgement.
A fund manager (and their team) will be responsible for setting the parameters of the strategy, choosing investments, and deciding when to buy and sell.
The management of the fund can vary, for example:
- It may trade frequently, or it might buy stocks and hold them for the long term.
- It could buy direct equities, other funds, or a combination of both.
- It might keep a static asset allocation or vary it according to what is happening in the market.
Benefits
The benefits of active management are:
- Reassurance for the investor that someone is looking after their money.
- The ability to exclude or avoid particular companies or sectors.
- The possibility of high returns if the fund manager chooses the right companies to invest in.
- The fund manager can choose to diversify investments if the market tilts in a particular direction. For example, if technology companies are performing particularly well, the passive market will naturally hold more in this industry. An active fund manager could decide against concentrating too much in one sector, protecting the money against potential ‘bubbles.’
Drawbacks
However, the drawbacks are:
- The charges are higher for active management.
- There is no guarantee that the fund will outperform the sector or the passive equivalent.
- Active funds can be more risky, as the manager may have high conviction in a particular company or sector.
- While active fund managers often outperform the market during short periods, the likelihood of this reduces the longer you invest.
- Fund managers are increasingly applying technological analysis to their investment decisions. While this reduces the risk of human error, it does raise questions. If all fund managers have the same information and capabilities, what sets one above another?
- Adopting an active approach may mean not sticking with the same fund manager if their performance drifts back to ‘average.’ Buying and selling frequently can increase costs, as well as missing out on growth when funds are out of the market.
Passive Investing
Passive investing means investing in line with the market. The goal is not to beat the benchmark, but simply to capture market growth in a predictable and low-cost way.
A passive fund might be multi-asset in nature, or it could focus on a particular region or sector. It’s possible to build a diverse portfolio using only passive funds.
Benefits
The main benefits of passive investing are:
- The costs are lower than for active management.
- The portfolio will naturally favour successful companies as these will take up more of the market share.
- The choice of passive funds today means that it’s possible to create a globally diverse portfolio of multiple asset classes.
- The evidence suggests that over a longer time period, a passive fund is likely to perform just as well as the active equivalent.
- Returns are more predictable as they will move with the market.
Drawbacks
However, there are some potential disadvantages:
- While the fund will aim to replicate a particular market or index, it is rarely a perfect mirror image. Charges and potential tracking errors can mean the fund continually performs slightly behind the market.
- There is no scope to apply specific ethical restrictions to a passive fund.
- As the fund moves with the market, this can mean buying into certain areas at a high point. For example, technology companies performed exceptionally well in 2020, which means they formed a higher proportion of the relevant markets. Buying a passive fund could result in holding more in these companies than you would otherwise choose to.
Efficient Market Hypothesis
The efficient market hypothesis suggests that the prices of funds and shares reflect all known information at that time. With today’s technology, the markets simply move too quickly to make any meaningful gains on the back of world events or news items.
Some active fund managers do gain an advantage through their research and data analysis. But this usually applies over the short term (bearing in mind that strong short-term gains will make the fund look better over 1, 3, or even 5 years).
To properly assess if a fund has consistently outperformed, you should look at the longer term, 10 years or more. When you consider that you plan to invest over a lifetime, a 5 year performance history is pretty insignificant.
It’s also worth comparing the fund to other similar funds. Many active funds outperform the benchmark or sector, but the average could be dragged down by exceptionally weak funds or poor market conditions. If the fund has produced similar performance to its direct competitors, perhaps it is not the fund that is exceptional but the segment of the market.
Charges
Investment performance is always uncertain. Investors are continually told, ‘the value of your investment may go up or down.’
Active management adds a layer of uncertainty. The fund is subject not only to the risks of the market, but the risks of the manager’s decisions within that market.
On the other hand, charges are a certainty.
Let’s assume you hold two funds, worth £100,000 each. You invest this money for 30 years and achieve gross returns of 6% per year.
On one of the funds, you pay charges of 0.50% per year, while on the other, the charges are 1.50%.
The fund with the lower charges will be worth almost £500,000 at the end of the 30 years.
The fund with the higher charges will be worth around £375,000.
This means that all things being equal, the extra 1% in charges has cost £125,000 by the end of the term. This is due to lost investment growth as well as the direct impact of the charges.
While there can be good reasons for investing in active funds, you need to be sure that the additional cost offers value for money when compared to the passive equivalent.
