An argument which has long raged in the halls of asset managers is the debate between investing styles. In particular; passive versus active investing.
Financial Expert encourages one of these styles – we will use this article to explain which style we prefer, and why it has won our support.
An active investor uses discretion to select individual investments that they believe will beat the market.
An active fund uses a highly paid fund manager to ‘stock pick’ and hopefully generate higher returns.
A passive investor accepts that they will not beat the market, and invests in a ‘bit of everything’ in order to generate the average market return.
A passive fund will aim to match the return of an index by investing in most companies in the index. Therefore mathematically the return of the fund will always closely match the market average.
Passive versus Active investing style matters when starting out
You will be forced to pick a side in this debate at the beginning of your investing journey.
Firstly, you will choose whether to invest in individual companies or use funds to diversify your portfolio easily. This is a choice between active and passive approaches because making individual investments requires stock-picking.
Even if you choose to build your basic portfolio using funds, a second choice appears. Will you choose to invest in funds with an active management style, or choose funds that passively track an index?
To help you understand the pros and cons of each approach, we will analyse the positives and drawbacks of each investing style in the following sections.
The advantages of actively managed funds
When investors are asked why they choose funds with active strategies, they explain that they want an expert to be in charge of their investments. They want a finance professional to use knowledge, wisdom and research to make good financial decisions on their behalf.
This an undeniably sensible thought process. Are you able to think of another industry where the best outcome is not at the hands of its most skilled experts?
If a fund manager is not using their skills to actively predict which companies, industries and markets will be the next big thing – why are they worth paying?
Indeed, fund managers of large funds typically have a distinguished CV, including prestigious formal education and extensive practical experience. Fund manager positions at top asset managers are few and far between, and therefore competition for these roles is high.
For an uninformed investor who doesn’t know or care about the difference between QE3 and BASEL III, it’s easier to sleep knowing that one’s money is in the charge of someone who does.
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2. Size matters
As a large institutional investor, funds receive access to investments that are not available to small private investors. These include placements of corporate debt, the ability to invest in hedge funds.
This provides opportunities. For example, large companies are happy to pay a higher rate of interest on a bond, in return for having fewer, larger bondholders as this may allow them to restructure their debt at a later date.
Passive funds would not have permission to invest in a new, one-off investment, as it is unlikely to feature in the benchmark index that they track. Passive funds would therefore all pass up on the opportunity.
3. Informational edge
Active fund managers and their research teams have their ears very close to the ground.
Using ultra-fast 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.
Whether it’s an advantage of several minutes or even just a few seconds, possessing an informational edge provides an opportunity to beat the market.
4. Superior returns before fees
The factors above are reflected in the historical returns of actively managed funds.
It has been demonstrated that they do in fact achieve a higher return than the market average before fees are taken into account.
5. Less involvement = less stress
Compared to the buying of individual shares yourself, handing over responsibility for the management of a portfolio to an active manager sheds the burden of active investing.
DIY active private investors may feel a compulsion to check on share prices multiple times a day. In contrast, many people who invest in mutual funds don’t even review their progress once per month.
Investing is a long term game, and obsessively following the ups and downs can be counterproductive. Short term movements can inspire unwise trading which increases fees over the long term. One theory is that active funds provide the peace of mind that ‘someone else is dealing with’ the news and events. This reduces the need for an investor to obsessively follow the market movements themselves.
6. Useful in obscurity
In small foreign equity and bond markets, where information is not easily available, stock markets work less effectively and prices are less reflective of an assets true underlying value. In such markets, active managers have been able to justify their returns because their independent research can deliver a real competitive advantage.
The disadvantages of actively managed funds
1. Higher management charges eat away the premium return
While is it true that actively managed funds do slightly beat the market on average, this is before annual management charges are taken into account.
|Fund||Strategy||Ongoing management charge|
|Vanguard FTSE 100 Index Trust||Passive||0.06%|
|iShares Core FTSE 100 UCITS ETF||Passive||0.07%|
|Fundsmith Equity||Active||0.95% - 1.55%|
|Fidelity UK Opportunities Fund||Active||0.67%|
This table lists some of the most popular active and passive funds which invest in UK equities. The selection is small, but you can clearly see there is a wide gulf between the charges of an active fund versus a passive fund.
This means that active funds must consistently outperform by more than their management charge to be the stronger option.
Simple research has demonstrated that they do not.
‘Nine out of ten active funds fail to beat their benchmark‘ reported the Financial Times in 2015. It was describing research findings from Standard & Poors, a financial information company, who had published a study into historical returns.
S&P found that 86% of active UK funds failed to beat their benchmark in the preceding year. Over the previous ten years, 75% had underperformed their benchmark.
This means that in the majority of cases, simply tracking the benchmark, (i.e. a passive strategy) would have produced a higher return.
This is a crucial point in the debate because the prevailing wisdom in support of the active approach is that paying for expertise will ultimately deliver a higher return.
2. Initial fees
As we explain in our article How to Reduce or Eliminate the Cost of Investing, active funds occasionally feature ‘Load’ or ‘Initial’ fees. These deduct a percentage of your funds before they are even invested.
We are happy to report that by looking carefully at fund factsheets, you can avoid any funds that still charge this outdated fee.
3. Investors still need to pick a winner
As we stated above, investors flock to active managers to leverage the manager’s expertise to make financial decisions on their behalf.
However, only a minority of active funds outperform the market average. This leads to the unhelpful situation whereby decision-averse investors need to somehow decide which fund will be a winner.
Wasn’t the benefit of active management that investors wouldn’t need to make difficult decisions between winners and losers? The odds are stacked against an investor in making this choice.
4. ‘Survivor bias’ hides failure
An investor choosing an active fund will need to acknowledge a mysterious force: survival bias.
Funds are not forever. Fewer than half of the 489 UK equity funds and 1,192 European equity funds that were launched 10 years ago have managed to survive. This is worth repeating. Half have closed.
Funds are usually closed by their fund manager after they perform poorly.
This means that the range of funds currently on offer does not represent the full experience of the fund industry. They represent only the funds that happened to perform well, regardless of whether this was through skill or luck.
To avoid survivor bias from compromising your decision making, keep the following in mind:
- A fund manager with a glowing range of well-rated funds may have produced an equal number of terrible funds, which are now hidden from view. Therefore you cannot be certain that the fund you have picked will not also suffer the same fate in future years.
- Glancing across the market, outperformance may appear to be the norm. This can give a false impression that active funds generally win. The research above demonstrates that this is not the case when you include all funds.
- Fund outperformance can be caused by other factors beyond skill. A fund could perform better because the manager took higher risk, or because of simple luck.
5. Even a goldfish could become a ‘star fund manager’
Following on from the above. Here’s a thought experiment which hopefully explains why the survivor bias concept provides such a critique of the fund management industry.
- Scientists could allow goldfish to ‘make a prediction’ of the outcome of a coin flip, by recording whether they swim to the left (heads), or swim to the right (tails) in a given period.
- If 64 fish swim randomly, half of them will correctly guess each flip.
- If the fish are moved into another tank if they lose, the remaining fish increasingly begin to look like they possess the sight! After six games, approximately one fish will still have a perfect track record of winning. A real star performer!
In a scenario with fish, it is easy to keep track of the fact that despite the excellent credentials of the surviving fish, the actual probability of it winning the next game have not actually increased from 50%.
So when we look across to the fund industry and see the ‘top 10’ type funds which claim to have beaten their benchmark over the last few years – who’s to say these aren’t just the lucky fish?
The advantages of passively managed funds
1. No initial fees and low ongoing charges
Passive funds cater to fee-conscious investors. The standard passive strategy of investing in all companies in an index is cheap to management. A passive fund requires little research and does not need to pay the multimillion-pound salary of a star fund manager.
As such, passive funds, which usually come in the form of Exchange Traded Funds (ETFs), never charge loading fees, and have the lowest ongoing charges in the industry. When paired with a low-cost stocks & shares ISA, a retail investor can access a diversified portfolio for a fee worth a very small % of their portfolio value.
And remember, each pound saved is a pound earned.
2. Almost match the market
Rather than trying to beat the market, a passive fund merely replicates it as closely as possible. This creates a significant pressure on fund managers to keep their fees low. The lower the fees, the closer the fund will be to the market return.
As we explained above in the active section, research has shown that being able to almost match the market will beat an active fund most of the time.
The disadvantages of passively managed funds
1. Knowledge of diversification and markets needed
Many active funds on the market provide a one-stop-shop for equity investors. For example, funds with ‘global’ in their title will spread money across multiple markets.
Passive strategies tend to focus on a single geographic area. This places a larger burden on the investor to ensure that their portfolio has a suitable mix of passive funds that provide sufficient diversification.
There are exceptions to this rule. For example, Vanguards ‘LifeStrategy’ fund invests in equities around the world. It then goes one step further by including a percentage of corporate bonds. The result is a single passive fund which could replace an entire retirement portfolio.
2. Tracking error
The stated objective of most passive funds is to replicate the return of an index. However, the operational realities of how funds work mean that actual performance will vary.
This difference in performance is called the tracking error. Tracking error is caused by:
- Management fees
- Trading costs
- The impact of the bid/ask spread
- The need to hold some cash
Most of these reasons reduce the size of the fund assets, therefore tracking error is typically a shortfall in performance.
3. Synthetic funds bring counterparty risks
The passive fund will use investors money to invest across each company or bond that forms a particular index.
However, some funds have found that it is cheaper or easier to use derivatives to gain the same exposure.
A derivative is essentially a bet between two institutions. The passive fund will bet that the index will rise, and the opposing party takes the opposite bet. The outcome of this bet would be similar to owning the shares themselves.
This can be a practical solution for a fund manager trying to replicate an index of 1,000 companies without paying thousands of trading fees per day. It could also provide a fund manager with exposure to an asset class which is difficult to invest in, such as emerging markets with rules that restrict investments by foreigners. However, it is most commonly used in funds that mirror the price of Gold and Platinum.
The dark side of this ‘synthetic’ approach is counterparty risk. Counterparty risk is the risk that the opposing player becomes bankrupt and is unable to pay its obligations to the fund.
To minimise this downside, funds usually require the counterparty to hold other assets as security or collateral against any payout. However, this does not eliminate the risk completely as those assets could fall in value or become difficult to sell.
To check whether a fund uses a real or synthetic approach to investing, look at its fund factsheet. Synthetic funds use terms such as
Synthetic ETFs must name the counterparty, which is usually an investment bank such as Deutsche Bank. The counterparty may also be referred to as the ‘sponsor’.
The overall winner of passive versus active investing: PASSIVE
We support a passive investing approach in our Financial Expert articles because it has been proven to offer a consistent way efficient to access market returns.
All investors dream of making a perfect judgement and riding it to riches. However, the real data has proven that active fund managers do not deliver enough superiority to justify their fees. Active investors suffer as a result.
The active fund industry is becoming the dinosaur as the passive strategy becomes more and more popular.
The Financial Times reports that the value of money in passive equity funds have grown by more than 700 per cent since 2008 in the UK.
$100bn was held in passive exchange-traded funds worldwide at the turn of the century. This has swelled to $4.6tn at the end of 2018, according to data from consultancy ETFGI.
Active managers still have the lion share of assets when one zooms out, however, we believe this is due to their strong legacy advantage. It often takes a big event to motivate someone to finally switch their investment provider.
The combination of reforms to financial advice, better online tools, and decreasing loyalty all translates to mobile money. While passive funds saw inflows during 2018, active funds saw net withdrawals.
This is a trend that we expect and hope will continue.
Passive versus Active Funds
An active strategy uses a fund manager to ‘stock pick’ to try and beat the average market return.
A passive strategy invests in most companies featured in the benchmark index, in order to closely match the market average.
Active managers succeed in attracting clients, despite higher fees, because of an intuitive belief that experts in their field can deliver better than the average.
However, data suggests that this rule breaks down in a market full of similar professionals. By definition, only half of players can beat an average. Once fees are deducted, only 25% of fund managers beat their benchmark. It is difficult to prove that this outperformance isn't anything more than luck.
Passive funds are cheap to run because their strategy does not require expensive market research. Unlike active funds, which can charge upwards of 1% per year, some passive funds charge less than 0.1% in management fees annually.
Low fee structures allow a passive funds to closely track their benchmarks and keep tracking error (the difference between a fund return and its benchmark) to a minimum.
In small foreign equity and bond markets, where information is not easily available, active managers have been able to justify their returns because their independent research can become a real competitive advantage.
Modern investors are still divided on the merits of these investing styles. Both strategies have large sums of assets under management. However, money is gradually shifting into passive management.
Next Article in Course
Before you move on, please leave a comment below to share your thoughts. Which type of investing strategy do you support? Do you have any other arguments to add to the debate?