Broadly speaking, there are at least two investment approaches: “active” and “passive”. Many people believe the former to be superior to the latter, perhaps imagining professional investors running around Wall Street or the London Stock Exchange to “buy” the best investments and “sell” the worst ones on behalf of their clients.
Indeed, even the name “active investing” suggests that it is somehow more vigilant or hard-working than “passive” investing, which sounds somewhat lazy.
However, what exactly are the differences between these two types of investing? Why is active fund management often seen to be superior to passive investing, and are these perceptions justified? If the reverse is actually true (i.e. passive investing is superior) then why would so many people believe active investing to be better?
Let’s turn to each of these questions in turn…
Active & Passive Investing: What’s the Difference?
As the name suggests, active investing takes a more hands-on approach when it comes to choosing investments for a client’s portfolio. As a result, an active fund manager is required to run the portfolio each day, trying to “beat” the stock market by seeking to exploit short-term fluctuations in stock prices.
In particular, if a client’s stocks in a particular company look like they are likely to fall imminently and significantly, then the active fund manager can “sell” the stocks and invest the money elsewhere – particularly in stocks which appear set to move in the opposite direction.
Passive investing, however, involves committing capital towards a particular set of investments and “holding on” to them. Buying and selling are minimised, and quite often investments within the portfolio will follow a particular index on the market (e.g. the FTSE 100).
This means that a passive fund manager is not required to manage the investments of a particular fund; rather, the value of your investments rises or falls within the movement of the index(es) you are following.
Why do People Think Active Fund Management is Better?
Active fund managers would argue that many people believe their investment approach is superior due to the better results they produce. However, these claims are difficult for most active investors to justify with empirical evidence (which we will examine shortly).
There are at least three other possible reasons as to why active fund management still maintains such a powerful perception amongst investors, despite its track record:
Human psychology
-
- . According to writer and researcher
J. B. Heaton
- (University of Chicago), human beings have the tendency to assume that “good returns are more likely if accompanied by hard work”. In academic circles this is known as the Conjunction Fallacy. Put simply, just because an active fund manager watches your investments every day and “moves them around” (through buying and selling), this hard work does not automatically translate into better returns. However, our brains tell us that it must produce better results – otherwise, why would the fund managers work so hard?
Money & marketing
- . Put bluntly, active fund managers represent a very wealthy and powerful sector within the British economy. Lots of money goes into advertising the benefits of active fund management to prospective investors, and they can afford to employ the best marketers to ensure that their message lands effectively.
Hollywood
-
- . There are plenty of popular films which have attempted to portray the investment world, and it would be fair to say that these largely centre around an image of active investment management (e.g.
- ). This can reinforce a popular perception that active fund management is the “real” or “proper” way to “do investing”.
Active & Passive: Which is Best?
When it comes to looking at the ever-growing wealth of research and evidence regarding the performance of active fund management, it does not generally support active fund managers’ claims about the extra value they provide to clients compared to passive investing.
For instance, take the common argument that active fund managers tend to outperform index funds during “bear markets” (i.e. when share prices are falling). In most cases, research tends to demonstrate the opposite. In 2019, for example, only 20% managed to beat prominent UK indexes in the year to the end of June 2019.
However, active fund managers not only face the challenge of being able to consistently beat the market (a near-impossible task), but they need to provide additional returns to their clients in order to cover their higher costs, relative to most index funds. After all, it costs more money to employ an active fund manager to oversee a portfolio, and to regularly buy and sell the investments. However, once again most active fund managers fail to achieve this and often even conceal their costs to their clients. Indeed, in 2017 the Financial Conduct Authority (FCA) found that the average fee for an active fund is 0.9% p.a compared to 0.15% p.a for a passive fund. However, clients of active fund managers often pay even more without realising, due to more “hidden costs” such as trading and admin fees.
Invitation
At FAS, we believe strongly in an evidence-based investment approach when it comes to providing value to our clients. In general, we would argue that blending strong, consistent, actively managed funds with passive funds, will yield better returns than a portfolio that concentrates on only one approach.
Although nothing is completely certain with investing, this approach can be more effective at minimising your risk exposure and enables you to improve your returns by controlling more of the costs of your investments.
If you want to discuss your own investment strategy with one of our experienced financial planners here at FAS, then please give us a call.
This content is for information purposes only and does not constitute investment advice or financial advice.
