Active, or passive, or both?
Taking sides in the great debate
Daniel Lane, Fidelity Personal Investing, 12 September 2019
Who can do it better? That’s the question all fund managers are trying to solve, hence the vast range of funds out there and the intricate strategies behind them. For us mere mortals however, the question is whether to buy into their stock picking expertise at all, or opt for a hands-off approach designed to match the performance of an index, like the FTSE 100.
And here begins the debate over active and passive investing, pitting research and investment nous against the simplest strategy possible.
Wars have been fought over less but you needn’t get caught up in the rivalry because both options are there for you to pick and choose from. Here’s a rundown of the cases for both and how some people blend them to meet their needs.
Active - tapping into the experts
Actively-managed funds are, as the name suggests, run by a fund manager. They decide what to invest in and how much of the fund to invest in a particular stock, sector or country. They will also keep an eye on wider economic and political events that have an effect on stock markets and could affect investments within their fund.
Take a UK fund manager for example - they will sift through all the London-listed companies out there and come up with a select group they consider the best of the bunch.
The aim of these fund managers is to deliver the best returns they can. That might mean beating the rest of the market, or for funds with a more conservative investment strategy that might mean protecting capital and losing less value when markets fall.
Of course all that experience and expertise that you get from a fund manager’s team doesn’t come for free. And one of the biggest drags on the performance of your fund can be the costs involved with investing. For the privilege of investing with an expert fund manager, you often have to pay higher fees than you would with a passive fund. However, if your goal is to outperform the market rather than simply matching it, the active route might be for you.
Passive - matching Mr. Market
Passive funds are very different. Rather than being actively run by a manager, passive funds aim to simply emulate or track that index instead. That’s why you’ll often hear them referred to as index or tracker funds, as well.
The trade-off here is that these funds won’t outperform the market but, as a result, carry lower costs.
Horses for courses
Why so many people choose to invest in actively-managed funds is because of the potential they have to deliver superior returns than a simple tracker fund. If they get it right, an active fund manager offers the potential for higher returns.
As a private investor, with your own day job to do it’s nigh-on impossible to find the time to immerse yourself in the stock market and the wider world of investments to the extent that fund managers are able to do on a daily basis.
Analyst teams dedicate a large part of their time getting to know the companies they invest in. As well as building a picture of them from the ground up and comparing them to other companies in their sector, they will often make regular visits to see how the company operates first-hand and get to know the senior management teams.
Of course, active funds need to outperform the market to the tune of their fees, and if they don’t the extra cost involved can be frustrating, especially if a passive equivalent has done better over the period.
Core and satellite
Of course, it’s entirely your choice, and quite often it comes down to using both strategies in different parts of your portfolio. If active managers pride themselves on spotting inefficiencies in the market (i.e. companies trading at a cheaper price than they’re worth) then it stands to reason that the under-researched or less well-known parts of the market can be a bit of a playground for them. Emerging markets and smaller companies often come into the conversation here.
Conversely, markets with investors poring over every detail of every company announcement tend to be more efficient, because all knowledge is widely shared and acted upon - so there’s less opportunity to spot something everyone has missed. Sometimes people mention the US market here.
A good idea is to use a core and satellite approach, keeping costs low with a central passive element to the portfolio where you feel it’s necessary, with some satellites into specific areas where you really feel an active manager can add value over and above the index.
Important information The value of investments and the income from them can go down as well as up, so you may get back less than you invest. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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