Active or passive investing – which is best?

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Investing

Gareth Trainor

14th February 2017 at 4:00pm

While psychologists toil over nature against nurture and biologists battle over the chicken or the egg, the investment world has its own conundrum – active or passive investment.

What’s behind the great investing debate?

It’s one of the oldest disputes in the investment arena and one that’s raged for decades. Knowledgeable and experienced investment professionals staunchly defend both sides and, over the years, a wide variety of studies have been commissioned to answer the fundamental question: which is best active or passive fund management?

Passive fund management: the same returns as a market or benchmark

A passively-managed fund should match the performance of an index benchmark rather than beat it.

For instance, the UK stock market is made up of all the publicly listed companies in the UK. The performance of this is regularly measured and quoted in the news through an index such as the FTSE® 100 (the biggest 100 listed companies in the UK).

Passive fund managers then aim to ‘track’ this return – or match the performance as closely as possible. So, if the market goes up or down, their fund performance (before charges) will also go up or down.

The passive fund manager will normally do this by investing in the same shares as the index benchmark, or ones that will perform in a very similar way.

 

So why would I pick a passive fund?

If a passive fund mainly invests in the same shares as the stock market, what’s the appeal?  One of the benefits to passive investing is cost – passive funds tend to be cheaper than active ones.

It’s worth being aware though that, in practice, if you choose a passive fund your return will rarely be as good as that of the benchmark because of the charges you’ll pay. Your performance will generally underperform to the extent of the charges.

Commonly, people who invest in passive funds don’t believe that active fund managers can consistently add value over time and so prefer to experience the full ups and downs of the market. Meanwhile, others think that active managers can do better than the index benchmark, and in some instances, significantly so.

 

Active management: aiming to beat a benchmark

Putting it simply, an actively managed fund is one which is run by a fund manager who tries to outperform an index benchmark, or peer group, over the longer term. They do this by making decisions about which of the companies in the market should or shouldn’t be included within the fund.

For example, take an actively managed equity fund, which invests in the shares of UK companies. The fund manager will review the shares in the fund regularly and make an active decision on which to keep in the fund and which to remove or add.

Active fund managers usually do extensive research to help them select the shares they think will perform well in the future. Different funds have different criteria or strategies to select investments, and can have very different levels of risk.

Investors can choose from a huge number of active funds, but each fund aims to perform better than someone investing passively. Most try to beat some particular market or benchmark.

 

Why choose an active fund?

Those who prefer active funds like the idea of the potentially better returns that active management can bring. Of course, it’s always worth being aware that what’s performed well in the past may not always produce good returns in the future.

For instance, over the past three years to 31 December 2016*, of the different funds that invested in UK shares, the best one had growth of 52.2%, and the worst was -1.3%. Over the same period, the FTSE® 100 return was 18.4%.

There are certain situations where active funds are the only choice. For example, if you’re looking for specialist investments such as a particular industry, strategy (like values-based investing or ethical funds) or for certain asset classes such as commercial property. In these cases, you might not be able to find a viable passive fund to invest in.

 

So which is best?

As with most hotly contested debates, there’s no definitive answer as both sides hold their merits.

Let me use a common-day analogy – fine dining versus fast food. Personally, I quite like having both in my life. Sometimes I want something easy, quick and predictable (especially if the kids are with me) so fast food appeals.

At other times, I’m willing to pay more to have a ‘finer’, more tailored experience – although this can be much better, it can sometimes provide mixed returns compared with the low cost predictability of fast-food chains.

As with the dining comparison, there’s no categorical evidence that active is better than passive investing in all circumstances – or vice versa. Therefore, the answer is simple – you might want to consider using both and use them as and how you feel best meets your investment goals.

*Source: Financial Express, based on the IA UK All Companies Sector on a total return basis from 31 December 2013 to 31 December 2016. The figures used are for illustrative purposes only.

The value of any investment can go up or down and may be worth less than was paid in.

“FTSE” is a trade mark of the London Stock Exchange Group companies and is used by FTSE under licence.

The information in this blog or any response to comments should not be regarded as financial advice and is based on our understanding in February 2017.

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