The retail fund management industry, which was established in the 1920s, was built on the creation of actively managed pooled investment funds, where fund managers and management teams take frequent investment decisions to their portfolios, with the aim of beating a particular benchmark or target index return. The 1970s saw the creation of a challenger to the fund management industry, when the first index tracking funds were launched. These are funds that operate with far less human interaction and decision making, and manage funds by looking to mirror or track the performance of a particular index or set of indices.
Index tracking funds have steadily gained popularity as the decades have passed, so much so that the amount of new money invested in passive investments now outstrips actively managed funds. However, despite the rise in passive usage across the world, the debate still rages as to which approach can yield the best returns for investors. As we will demonstrate below, we feel that both approaches have merit, and combining the two distinct investment styles can often be an appropriate solution.
Active can outperform
The key difference between the potential returns from an active approach is that the fund can beat returns achieved by the market generally, if the fund manager or team get the investment calls right and hold more in positions that perform well. This is simply not possible through a strict passive approach, where the returns can only mirror (or usually lag slightly behind) the returns achieved by the representative index. As the main driver for most investors is to seek outperformance, this places active funds at a distinct advantage; however, this is only the case if the active manager or team can consistently beat their benchmark.
Another potential positive is that active managers have the flexibility to adjust their portfolios in periods when markets perform less well, therefore potentially reducing the impact of a period of weakness on the fund’s performance.
However, the success of the strategy will largely be dependent on the skills of the manager or management team, and the analysts they employ. Some active fund managers have built up a strong track record of outperformance over many years, and have proven themselves over a range of different market conditions. There are others, however, where performance has lagged benchmarks consistently, and therefore careful analysis of the approach, style and past performance of the fund manager are factors investors need to consider when selecting actively managed funds.
The teams of analysts and fund managers employed to manage an actively managed fund do, naturally, increase the running costs of the fund. This is passed on to investors through higher charges than are typically charged when holding a passively managed fund. For this reason, it is important to achieve good value for money when considering active funds.
The positives of passives
When investing in a passive fund, the first important point to consider is that you are highly unlikely to outperform the representative index that the passive fund aims to track. Even passive funds that fully replicate an index are likely to underperform the index slightly due to charges and tracking error.
It is also important to note that the very nature of passive funds means that the performance is purely driven by that of the underlying index. There is no ability for a human fund manager to take decisions to protect a portfolio in periods when markets perform less well. For example, a fund manager of an active fund could look to increase cash positions within the portfolio, or reallocate the balance of the portfolio to take advantage of underlying conditions.
That being said, there are distinct advantages that a passive fund can provide. Firstly, as the fund tracks an index, the investment will provide exposure to a good proportion, or indeed all of the constituent holdings within the index. This provides good levels of diversification across a range of different sectors, which is difficult to achieve from an actively managed approach. That being said, we often review actively managed funds where the portfolio does not deviate significantly from the composition of the underlying index. If an active manager was closely replicating an index, it begs the question what are you, as the investor, paying for?
Low charges are the other area that passives have an advantage. Given the lack of a human manager, passive fund management charges are generally much lower than active funds.
No winner, but plenty to consider when asking ‘Do Active Managers add value?’
As you can deduce from our analysis above, both active and passive investment management styles have features that make them attractive to investors. At face value, a passive investment approach is the most cost effective method of investment, and also potentially offers greater diversification over an active approach.
However, there may be a cost to using passives, which is the potential underperformance compared to an actively managed fund which outperforms the representative market and its’ peers. Given that active managers can often outperform the benchmark by several percentage points of performance each year, and potentially often downside control through asset allocation, this makes quality active funds an attractive proposition. But what if an active manager runs into a rut, where performance disappoints and lags the performance of similar funds? This is a situation avoided by a passive fund, and therefore when selecting active funds, there is heavy reliance on choosing the right fund from thousands of funds available to UK investors.
Our Investment Committee at FAS undertake regular and comprehensive due diligence across a very wide range of funds available to UK investors, to seek out strong performing active funds. We also regularly review passive investment approaches and look to select the right approach for each sector and asset. Speak to one of our experienced financial planners if you would like to review an existing portfolio, or invest funds using a blend of cost effective passive funds and attractive actively managed funds.
If you would like to discuss the above further then speak to one of our advisers here.
The value of investments and the income they produce can fall as well as rise. You may get back less than you invested. Past performance is not a reliable indicator of future performance. Investing in stocks and shares should be regarded as a long term investment and should fit in with your overall attitude to risk and your financial circumstance.