Passive Investing vs Active Management

Passive Investing vs Active Investing, Active vs Passive Management, whatever you want to call it – the debate between active and passive investment strategies has been raging on for two whole decades. At stake: the future of the lucrative actively managed funds industry. In this article I weigh up the debate between actively managed mutual funds and passively managed index funds.

Total assets under management in mutual funds in 2008 was: wait for it, $18,900,000,000,000. Yes, that’s 19 trillion US dollars, and doesn’t take into account the $24 trillion dollars in pension funds, $1.5 trillion in hedge funds and $1.6 trillion in private equity. Active managers levy fees on the assets they manage. These fees can be as low as 0.4% and as high as 3% per annum. At a conservative average of 1%, we can calculate that the mutual fund industry billed $189 billion dollars in management fees last year. Active management is big business.

The Advantages of Actively Managed Funds

1. Expertise. The number one reason why investors choose actively managed funds (AMFs) is because they want their assets to be managed by a professional. Love them or hate them, there is no denying that fund managers have a great deal of education, understanding and expertise in the financial markets. For an uninformed investors who doesn’t know their QE3s from their BASEL III, this can bring a great deal of comfort.

2. Size Advantages. Large mutual funds get access to special issues of investments aimed at institutions-only. These include placements of corporate debt, the ability to invest in hedge funds and other funds that only cater to institutional investors. Due to their scale, like anyway else in the marketplace, a better rate can be obtained. Corporations are happy to pay a higher rate of interest on a bond, in return for having fewer bondholders as this provides them with power to restructure their debt, and enter into dialogue that would be unfeesible if the debt were publicly owned.

3. Informational Advantages. Professional managers and their research staff have their ears very close to the ground. With the latest data terminals and news wires, you can be sure that an active manager will be one of the first traders in the market to react to news and events as they happen. While supporters of the Efficient Market Hypothesis would have you believe that prices react instantly to all new information – in reality they do take time to adjust, be it hours, minutes or even seconds. Having the informational edge improves your odds of beating the market.

4. Superior Returns. All of the above has an impact on the historical returns of managed funds. Actively managed funds DO tend to beat the market before fees are taken into account.

4. Less Involvement = Less Stress. Handing the responsibility for the management of a portfolio to an active manager helps to shed the burden of investing. While active private investors may check the major indices once or even multiple times a day, you will often find that lay people who put all their money into mutual funds don’t even check on the fund prices once per month! Investing is a long term game, and obsessively following the volatility of an index can be counter productive, given that buy and hold investors should be unconcerned by short term movements when redemption will be in a decades time.

The Disadvantages of Actively Managed Funds

1. Loading or Initial fees. Many active funds are sold through networks of financial advisors. Although this is subject to reform, advisors are most often paid commission by the fund provider. Fund providers fund this commission by charging new investors initial fees and forwarding most of this to your advisor. Initial fees range from 0 – 3%. This is equivilent to taking up to a 3% loss on your investment before you even get started.  Investors who want to invest directly with the provider still get charged this fee. The only way to avoid initial fees is to choose a no-load fund, or purchase a fund through a discount fund supermarket, which will refund you the commission it receives from the provider.

2. Management fees destroy the superior returns on funds. It’s a fact, mutual funds on average do not beat the return of the market after fees. This means from the perspective of an investors returns, they can expect to be worse off by investing in mutual funds as apposed to tracking the market (see passive management, below).

3. Picking active funds is the same as picking stocks. As I state above, the number one reason why investors choose mutual funds is that they want their expertise. However, in light of the fact that most underperform the market, the investor has to attempt to ‘pick’ an outperforming manager from the bunch. With no financial experience, this is the last choice an investor wants to make, as they wanted to eliminate financial decision making in the first place.

4. Mutual funds are not as liquid as other investments. Mutual funds typically only trade a few times per day, at the quoted ‘NAV’ price. This means that unlike a listed stock, a mutual fund cannot be bought and sold instantly at market price if needed.

The Advantages of Passively Managed Funds

1. No intial fees. Passively management funds cater to a discerning and fee-evasive crowd. As such, passive funds, such as the popular Exchange Traded Funds (ETFs) do not charge loading fees. You do however have to pay a broker commission to buy or sell ETFs, just like an ordinary share. Note: SOME passive funds may still carry charges, however these are likely to be lower.

2. Low management fees. Vanguard’s S&P500 tracker famously only charges 0.18% per year, which is truely a landmark as far as fees go. Such low fee regimes are typical of passive funds, which do not need to pay the wages of expensive researches or ‘star fund managers’. All else equal, lower fees equals a higher return to investors.

3. Almost Match the Market. Rather than trying to beat the market, a passive fund merely replicates it as closely as possible. This means that rather than having to gamble on a fund manager you ‘hope’ will outperform, you can simply invest in the market that you’re interested in, and ignore ‘quartiles’ and other active fund performance metrics.

The Disadvantages of Passively Managed Funds

1. Knowledge of diversification and markets needed. While you can invest in managed funds that take care of asset allocation for you, passive funds are usually specific to one index, and will require you to decide how to split your money across different areas. The plus side is that this can be a simple task if you want it to be, as you can see from some example allocations here. A well designed portfolio needn’t have more than 5 elements, (5 passive investments).

2. Tracking Errors. Index funds try to track an index, but inherent limitations in the operation of a fund as well as management fees will cause actual performance to vary. This difference in performance is called the tracking error. Tracking errors are caused by fees, as I’ve said, but also by the need for funds to hold cash to meet short term redemptions or awaiting investment. Trading fees will also deteriorate performance. For these reasons, tracking error is usually negative, however some years it may be positive (due to a fund holding some cash on a day when stock markets crash).

3. Synthetic ETFs have counterparty risks. The simple fund will take investors money and invest it in a basket of shares or bonds. However some index funds have found that it is cheaper to use derivatives (a promise from another institution, usually a bank) to provide the index returns. These are called synthetic ETFs. Examples would be this list of synthetic gold ETFs. This avoids the practical issues of trading and holding cash, but introduces counterparty risk into the mix. Counterparty risk is the risk that the bank may not be able to meet it obligations, and would default on the derivative contract. In this case, the index fund would collapse. As this is a terrifying scenario, banks put up collateral equal to at least the expected obligations, such that if the bank went bust – the fund could liquidate the securities and pay its members. However, recent concerns have been expressed that banks are taking advantage of the situation by only offering their poor quality, hard-to-sell assets that may lose value and liquidity in a financial crisis. It should be noted that no synthetic ETFs entered financial difficulties during the 2007-2009 banking crisis. Of course to avoid such counterparty risk, one can opt for physical ETFs such as this list of physical gold ETFs.

The Overall Winner: Passive Investing

When everything is taken together, it becomes clear that passive investing produces the highest expected return. You do need a minimum standard of education to understand what you’re doing and choose a sensible selection of funds, but the passive route should ensure that fees are minimised, returns are maximised and risk is as high or low as you want it to be (through altering your asset allocation). What’s more, passive investors will develop a much greater understanding of their investments over time, and should find the process far more enjoyable as a result.

Even passive investors may require financial advise. I recommend seeing an independent financial advisor who won’t be tempted to sell you high commission products. See ‘The different types of financial advisor‘ for information on the differences. If you’re unsure whether you should seek advise, read ‘Do you need a financial advisor’.

Passive investing may become difficult when investing in commodities and other alternative assets.

Simon OatesPassive Investing vs Active Management