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Active vs. passive funds

This is an article about funds and how they relate to investing in general.

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Active vs passive investing

Active and passive mode. But which is cuter?

One of the most significant aspects of an investment manager’s style is whether they are active or passive.

Actively managed funds, as the name suggests, are run by investment professionals who select investments they think will outperform the market.

In a chocolate shop, this would be someone hand-picking what they reckon are the very tastiest chocolates to put inside the box.

By contrast, passive index funds don’t aim to beat the market. They simply aim to mirror it.

They can reproduce the performance of a particular stockmarket index (like the FTSE 100) by buying the investments that made up the index, in the same proportion.

Typical fees

Active: 1.38%

Passive: 0.54%

Lipper for IM data, Q4 2014. Platform fee of 0.35% assumed. Active funds compromise of 0.75% AMC + 0.23% expenses.

These funds can be largely automated because they don’t need to carry out any analysis of the investments they buy or sell. They just follow a set of rules. If a passive fund was a box chocolates, it would be the standard selection packaged in the factory.

And the winner is?

Debate rages over which is better, but there are no simple answers. Some actively managed funds perform better than their passive equivalents in the same market – but the majority usually don't.

One solution would be to invest in the best performing active funds. The problem is spotting the winners in advance. There are simply no hard-and-fast rules to ensure success.

FOR PASSIVE  | AGAINST ACTIVE

  • Analysis by consumer site Which? reveals that only around one in three active funds managed to beat their benchmark between 2003 and 2013. Put another way, you only had a 38% chance of selecting an active fund that did better than the FTSE All-Share index.
  • Passive funds usually have lower fees, which is a significant advantage. In fact, the cost of actively managing funds is often what drags down their performance below the market average.

FOR ACTIVE  | AGAINST PASSIVE

Passive ways

Some passive funds offer full replication. For example a FTSE 100 tracker fund, may be able to hold stock in every one of the 100 companies listed in the index, in proportion to company size.

For indices with thousands of stocks, it may not be practical for the fund to hold every single one of them. Instead it may hold a representative sample. This partial replication means the fund may not always mirror the index exactly.

  • Passive funds have their disadvantages though, being by nature rather inflexible. They automatically buy more stock in the biggest companies in the index and do not consider the future performance of these stocks.
  • An index that simply tracks the largest companies in a particular market can also find itself weighted towards companies in a particular industry. For example, in the UK the FTSE 100 index has a relatively high exposure to the energy and financial sectors. This means a major event affecting  banks, or oil and gas companies, will strongly influence the value a FTSE 100 tracker fund.

The upshot

People who believe their active fund manager is able to add value, by beating the market more than they charge in fees, may choose an active fund.

For those not seeking to outperform the benchmark, a passive fund fits the bill. And of course, there’s nothing stopping you investing in both types (which is common practice among big institutional investors, such as pension funds).

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