For many investors, an active investment strategy appears to be a good idea. It can be reassuring to know that there is someone in the background, making informed decisions about how to invest your money. And more importantly, where not to invest it, since they will be more than familiar with the pitfalls of risky investments.
But recent years have seen an increase in the appetite for passive investment solutions. So what is the difference, and is it worth pursuing an active investment strategy?
The Argument for Active
Most of the traditional investment companies offer mainly active strategies. This means that a fund manager has responsibility for choosing the underlying investments, making switches and altering the proportions as necessary.
Now, there are many variations to this. Some managers actively choose stocks and trade frequently. Others prefer to buy and hold, adding new stocks as opportunities arise. Some aim for consistent asset allocation while others will shift proportions depending on what is happening in the market. In any case, a ‘bespoke’ service, including an element of expert judgement can be very appealing, particularly in this era of uncertainty.
But reliance on human judgement is fading, with most active managers now operating robust processes or complex algorithms to decide what they should include in their portfolios. With today’s technology and access to information, the talented fund managers of the past are being phased out in favour of teams of analysts and clever software.
While consistency and technology reduce the risk of human error, another question arises. If everyone has access to the same information at the same time, does any active manager genuinely have insight that the others don’t? And will that insight consistently lead to higher returns? By consistently, we are not talking about the last 6 months, or even the last 5 years. A 5 years performance history is not that significant when considering a 30 years retirement plan.
The Passive Position
Some may argue that active fund management is like trying to get ahead on a busy motorway. You can switch lanes, weave in and out of traffic and take shortcuts. You might gain a small advantage, but it is equally possible that your efforts will be counterproductive. Ultimately you will end up in the same place, and will probably have used more petrol.
A passive investment strategy does not attempt to perform ahead of the market, simply to participate in the growth. Passive investors generally accept the following to be true:
- The market is efficient. There is no point in trying to time investment decisions based on economic news or world events, as by the time you hear about it, it has already been priced into the market.
- Asset allocation contributes more to your performance than the individual stocks chosen.
- Diversification is vital, as the various asset types behave differently. When one goes up, others may go down.
- Diversification can lead to steadier long term growth.
- Charges are a certainty, while performance is unpredictable. It therefore makes sense to keep charges as low as possible.
A quick snapshot of the Mixed Investment 40% – 85% index (which is broadly comparable with a typical balanced portfolio) indicates that of the 170 funds within the sector, 71 outperformed the index over 5 years. 99, or 58% of the funds, did not.
In the UK All Companies sector, 85 out of 251 funds outperformed the FTSE All Share. This means that 66% of funds in the sector underperformed when compared to the average of the UK share market.
While it is simple enough to point out an actively managed fund that has outperformed its benchmark, the odds of choosing the right fund at outset and maintaining the outperformance over a lifetime of investing are extremely slim.
Of course, in certain areas, there is little doubt that an active manager can add value. Investing in certain sectors or economies requires specialist knowledge that a typical investor does not have. But this type of investment can be risky, and should form only part of a well-diversified portfolio.
What to Consider
There is a place for both active and passive funds in a diverse portfolio. These are our top tips for choosing between active and passive funds in the same sector:
- Look at the charges. If the active option charges 1% more than the passive equivalent, that’s 1% in extra performance needed every single year to be in the same position. Is it worth it?
- Has the active fund genuinely outperformed? Compare it to the passive equivalent as well as the benchmark. Measure the longest possible period – one year’s good performance is not statistically significant. Look at discrete figures as well as cumulative.
- How do the funds stack up when the market falls? Does one appear to provide better capital protection, even if the upside is lower?
- What do the funds invest in? For a straightforward equity fund, a passive investment may meet your needs best. Active funds may be more suitable if you want to invest in specialist areas.
- What are the trends in the sector? In some sectors, it is very difficult for active managers to outperform passives, while in others, passive funds lag behind.
At FAS, we can agree on an investment strategy with you, one that you understand and feel comfortable with, designed to meet your long term objectives that can help you face the future with confidence.
Please do not hesitate to contact a member of our team if you would like to find out more about your investment options.