One of the most enduring debates in the world of investment management is that between active and passive management. Which one provides clients with the best outcomes?
Active managers build portfolios by choosing to invest only in companies that they believe will outperform their peers, also known as ‘stockpicking’. Active managers use a variety of techniques to decide which companies to invest in. In some years active managers will outperform and in others they will fail to achieve their benchmark.
Passive managers take a more systematic approach. They try and replicate a market or index by buying each stock in proportion to its market representation. There are different approaches to passive management along the theme of market replication. Supporters of passive management believe that markets are efficient and in general terms a Company’s share price reflects its true value, so there is little to gain from active stock picking. Let’s look at the key areas in more detail.
Costs are almost always higher with active managed funds as there are additional costs associated with research and analysis. Conversely passive funds have lower costs due to the fact that the investment process is ‘systemised’. Cost is a key factor as an expense ratio of 2-3% on an active fund will have greater impact on the overall return than a passive fund with a lesser charge.
Here’s the big question, which one produces better return for investors? Unfortunately there is no clear answer to this, otherwise we wouldn’t be having the debate! The benefit of passive management is that the performance risks are more manageable as they will be closely aligned to the sector in which they invest, therefore eliminating a nasty surprise if the investment manager gets it completely wrong.
By its nature it’s true to say that with passive management you will never significantly outperform your market benchmark. However, it could be argued that you are more likely to achieve your long term objectives with a passive approach as the degree of uncertainty is lessened.
There is increased risk with active management as not only is there market or sector risk, but also the risk of the manager under-performing. Passive funds are not without risk. In addition to the inherent market risk there is also an element of manager risk as not all tracking methods are the same. Some will replicate the whole market, others will sample only a proportion of the index. As with active funds, the timing of buying and selling can also affect performance.
What do the academics think?
There have been numerous studies comparing the two approaches. Academics tend to sit on the side of passive management, often quoting the ‘efficient-market hypothesis’; the basis of which is that generally market prices reflect all market information, therefore it’s impossible to systematically ‘beat the market’.
The key advantage of active management, the potential to beat the market, is only useful if you can consistently select the winning managers. There is no systematic way of ensuring this is the case as future manager performance cannot be predicted. However, some investors want to take additional risk in exchange for the chance of achieving a higher return.
When a passive fund is used you know in advance that you will be achieving a return that is approximately in line with the sector or market it’s tracking. This approach is one that is favoured by many advisers who are focused on helping clients achieve their investment goals with the minimum amount of risk.
The debate will continue amongst advisers who often have a preference for one or other methodology. At Concept Financial Planning we do not have a preference for one over the other, what is important is the asset allocation decision, which we believe returns the majority of investment performance in a portfolio. We use both methodology when selecting how to invest in the asset classes, as we believe a blend can give you the best of both worlds. If you are looking to invest in UK equities and looking for dividend income can a index tracker fund provide you with this? Similiarly, why pay for active management on a gilt fund, when the cost can normally outweigh the addition return needed.
What is important however, and is crucially more the case with regards to active management on your portfolio, is that your investments are reviewed on a regular basis, this should include your risk profile and time scale for the investment to ensure that the asset allocation remains suitable and aligned to your financial goals.