Some experienced investors start from the premise that it is better to invest in active funds unless they cannot find an active manager they are convinced can outperform a particular market. Others choose to invest in passive funds unless they can find an active fund that can add value consistently.
Tom Rampulla, managing director at passive fund giant Vanguard, unsurprisingly takes the latter viewpoint. He says: ‘Our research illustrates just how rare it is for active funds to consistently outperform over the long term. The high costs that often go hand in hand with active fund management are a considerable drag on performance.’
According to Vanguard’s ‘Case for Indexing’ research, just 17 per cent of active equity funds and 4 per cent of active fixed-income funds in existence in 1997 outperformed their prospectus benchmark over the subsequent 15 years. The report showed similar levels of underperformance over five and 10 years.
However, those who favour active funds argue that passive fund investors are condemned to poor performance – the index less costs – and that finding top-performing managers, for example Neil Woodford at Invesco Perpetual or Hugh Young at Aberdeen, is not so difficult.
Tim Cockerill, head of investment at wealth manager Rowan Dartington, says: ‘We know the right active funds will outperform passives. In this debate, passive investors point to the average active fund’s underperformance. Well, no one should be aiming to buy the average or below-average fund and, of course, statistics shift all the time. The way I look at it, you’ve decided to invest, and to invest in an asset class and region. Why leave out the active bit that could enhance your return substantially?’
Money Observer’s coverage of consistently top-performing trusts and funds via its annual awards and the quarterly Premier League of star managers has served readers well in this respect.
The side of the fence an investor sits on will depend significantly on the extent to which they believe they can pick a fund manager who can outperform the market. In the long term, the average investor will generate a return equal to the market average before costs. The market is a zero-sum game. For the pro-passive gang, this means the average investor will benefit more from reducing investment costs than from trying to beat the average; for the pro-active gang, it means working harder to find the right fund manager at the right time.
That said, while investors tend to be on one side or the other philosophically, there is a strong argument for using both strategies, but for different parts of the portfolio. For example, David Hambidge, head of multi-asset at Premier Portfolio Managers, suggests passive funds can be the best way to access large companies on the US stock market, where it is particularly difficult to add value – it is hard to get an information advantage on a particular company when 70 to 80 analysts may be covering a single stock. In general, the argument runs that active funds may add greater value in less-established or less-liquid markets, such as those in emerging markets or smaller companies.
An active or passive strategy may be better for access to different asset classes. Cockerill says: ‘Exposure to commodities is a good use for ETFs, and indeed is the only way to get exposure in most cases.’ Hambidge agrees that passive structures can be the cheapest and most practical way of getting access to commodity prices such as gold, oil or agricultural products.
Other assets, however, are not naturally suited to passive investment. It is difficult to create effective passive strategies for illiquid markets such as property. Elsewhere, market capitalisation-weighted bond indices, for example, will have a higher weighting to the most indebted companies or governments. But this is not necessarily what investors want from a bond investment.
Strategies for lower-risk investors
For investors just dipping their toe in the investment water, possibly without the tools to make an informed judgement on a manager, passive funds can provide a cheap and easy solution. A core holding in a mainstream index is a good place to start building exposure to markets. This might be the FTSE All-Share or international indices such as the FTSE World. Investors should shop around on price and be comfortable with more of their investment being highly exposed to larger-cap stocks.
The active alternative is to go with a large, well-established manager running a properly diversified UK or international fund. The recommended lists of various online brokers – BestInvest, Chelsea Financial Services, Interactive Investor – are a reasonable starting point.
Strategies for medium-risk investors
Medium-risk investors may seek out passive funds for the cheap core of their portfolio in efficient markets such as those in the US or UK. From there, they might add spicier active managers that give a greater chance of outperformance. An alternative strategy would be to select a few core active managers to hold for the long term and then add racier, more short-term tactical holdings – in emerging markets or commodities, for example – using passive funds.
Strategies for higher- risk investors
Investors with a higher risk tolerance may have the skill and judgement to find the right active managers for most of their portfolio. However, they may use passive investments to take short-term exposure to individual markets – if they believe there is going to be a short-term rally in Japanese markets, for example.
They may also take positions in commodities, betting on the direction of the oil price. Increasingly, selective passive funds may also be able to enhance certain characteristics of a portfolio – to hike the dividend exposure, for example.
Ultimately, however, investors would be well-advised not to wed themselves too closely to either active or passive funds, but to recognise that both have a place in a portfolio, either for different markets or for different asset classes.
Active and passive fund basics
Active - An active fund is one that has a fund manager at the helm selecting stocks, bonds or property that they believe will increase in value. The manager will bring their investment experience and market knowledge to bear and strive to deliver a return over and above that achieved by ‘the market’. The market in this context is usually a given benchmark: the FTSE All-Share for a UK investor, for example, or the S&P 500 for a US investor.
Passive - Passive funds aim to replicate the performance of an index, such as the FTSE All-Share or S&P 500 indices, but without striving to exceed the return from that index.
The way individual passive funds track those indices varies considerably. Some are structured as open-ended funds (Oeics or unit trusts) – these are marked in our AnalyseMoney section with a red dot. Others are structured as exchange-traded funds listed on the London Stock Exchange (and others).
It should be noted that an increasing number of funds employ strategies that defy easy categorisation as active or passive, such as quasi-passive active funds and quasi-active passive funds. Confused? Quasi-passive active funds are low-turnover, low-cost funds, possibly run using a quantitative methodology. Quasi-active passive funds are ETFs that enhance an index by, say, screening all stocks for those paying a dividend and only investing in those.
Passive fund characteristics
Passive is cheaper. Passive funds are, on the whole, cheaper than active funds. There are no overheads for a well-paid fund manager, and often fewer trading costs. The annual costs for an exchange traded fund tracking the FTSE 100 index can be as low as 0.15 per cent.
Passive funds are readily tradeable. Passive funds are often large and liquid, so investors can move in and out quickly. This is particularly the case with exchange traded funds, making passive funds a simpler way to take short-term directional bets on markets. An active fund will have a manager’s skew and may not provide straightforward market exposure.
Passive fund performance depends on the benchmark. If a passive fund is based on a market capitalisation-weighted benchmark, such as the FTSE All-Share, larger stocks will be over-represented. If it is based on a dividend-weighted index, it will perform well when high-yielding stocks have a strong run.
Passive strategies can track esoteric asset classes such as commodities or volatility. For direct access to, say, the gold or oil price, a passive strategy – usually through an ETF or exchange traded commodity – is often the cheapest and simplest option. Frequently, the prices of quoted gold or oil company shares correlate with the prices of the underlying commodity, but the share price will also be affected by other factors, such as corporate management skill and balance sheet strength.
Passive funds may be less diversified. The FTSE 100, for example, is heavily weighted to the oil and gas, healthcare and banking sectors. A passive investor will hold relatively little in areas such as technology, retail or homebuilding.
Passive will not protect capital in a market downturn. Because there is no ‘intelligent oversight’, passive funds will simply track the market lower as it falls, rather than, say, put money into cash or more defensive areas as a fund manager might.
Active fund characteristics
Active funds will be more expensive. The average open-ended equity fund focusing on a mainstream market index such as the FTSE All-Share or S&P 500 costs around 0.75 per cent a year to manage. That said, costs are moving lower in response to increasing pricing pressure in the industry.
Active funds have a range of strategies that require analysis. Every fund manager has a style. They may prefer to invest in unloved ‘value’ parts of the market – companies trading at low share prices historically and unpopular with investors. Alternatively, they may prioritise companies with high growth. Investors must try to identify the best managers of their type.
Active funds can perform very differently from the wider market. An active fund might rise as the FTSE 100 falls or vice versa, depending on the strategy of the manager and the stocks they buy.
The best active managers add a lot of value. Over the 12 months to 31 May the FTSE 100 was up 24 per cent, according to FE Trustnet. The average gain in 268 funds in the UK all-companies sector was 31 per cent. The top fund was up 62 per cent. The weakest fund in this sector returned just 3.3 per cent.