Active Vs Passive Fund Investment

When it comes to investing in funds, active investment funds are run by fund managers who endeavour to ‘beat the market.’

Through meeting with the boards of large companies, meeting analysts who study their competitors and studying their own research, they develop a strategy that they believe will see them invest in the winners and dodge the losers.

Passive investing is where a fund tracks an index, for example the FTSE 100 is an index of the UK’s biggest 100 companies by capitalisation (value). So they are not making any judgement about which of these companies will do well, they simply invest in them all, and benefit from their overall market growth.

As companies drop out of the index from doing badly, others are growing so get promoted to the index. The index fund benefits from these market dynamics, and invests in the growing businesses, without having to make a judgment call.

Over the last ten years the total return for the FTSE 100 index was +103.98% with dividends reinvested, or a 7.38% annualised return. This is despite annual returns being mixed, with a range from a low of -8.73% to a high of +19.07%.

An active fund manager, when one of their investments is doing badly, has to decide whether to cut their losses or stick with the falling stock because their research will prove right in the end.

There are hundreds of market indexes to choose from. Common choices are the FTSE 100 or 250 in the UK, S&P 500 in America and Euro Stoxx 50 across Europe.

Which is best?

According to research by fund managers Lyxor, over a 10 year and 5 year period, respectively only 20% and 23% of European domiciled active funds outperformed their passive index competitor.

Designing a Portfolio of Funds

You can of course design your pension or investment portfolio to include some active and some passive funds, but you should be careful to avoid overlapping investments.

Picking Active Funds

When picking an active fund, you should check the Key Investor Information documents and fscsherts.

For any funds you are considering, compare the relative performance of the following:

• Manager track record
• Fund track record
• Target returns
• Historic returns
• Costs

And finally, you need to form a view on whether their investment strategy going forward is one you believe in (and how qualified you feel you are to make that decision?).

Beware of these three issues with active managers:

1. Stars Rise….And Fall

Beware investing in funds based on the manager’s track record alone. Fund managers that become stars do so off the back of terrific returns. In America the ultimate is Warren Buffet.

But even his returns are declining decade by decade - as he says, it’s harder to find ways to invest big sums of money.

Neil Woodford was one of the UK’s top stars for well over a decade at Invesco, but his funds were infamously closed after runs of bad performance and major withdrawals from institutional investors.

1. Smaller Portfolios Carry More Risk

While it has been proven that you can simulate the performance of a much bigger index like the FTSE All-World Index of the globe’s top 1,500 companies (excluding emerging markets), there are risks.

These risks tend to only manifest themselves in more extreme circumstances, such as a fund manager over-exposing their investments to a particular sector, major stock market volatility, or significant global events.

For example, during the Covid-19 Pandemic, top fund manager Terry Smith, CEO of the successful Fundsmith LLP, wrote to his investors and highlighted that their exposure to travel and leisure companies was likely to cause them problems during the crisis:

“If our equity in both is vaporised we will lose about 5% of our current portfolio,” he wrote rather glibly on 31st March 2020.

Investors in the FTSE All-World Index only have an exposure of 1.6% in the travel and leisure sectors.

A £100,00 passive investment would lose just £1,600 as a maximum, rather than the £5,000 Fundsmith investors will have feared.

1. Being Active Costs More

Active funds are more expensive. According to tracker fund advocate John Bogle active funds cost their investors an average of 2% more per year.

When you consider typical passive fund ‘market returns’ will be around 10%, you need an active manager to offer 12% returns at minimum to be even.

If their performance isn’t better than a passive fund equivalent, your investment is losing money in two ways.

Picking Passive Funds

When picking an active fund, you should check the Key Investor Information documents and fscsherts.

For any funds you are considering, compare the relative performance of the following:

• 5 year performance
• Tracking error vs target index
• Costs

You should also look at the fund structure, as there are positives and negatives to the different structures available: investment trusts, open ended investment corporations, unit trusts, and exchange traded funds.

Finally you need to understand whether the fund physically invests in the stocks of the underlying companies that make up the index. If they use derivatives and other ‘synthetic’ techniques you are taking on more risk.