The merits of active and passive investing have been debated for years, with an average of 35% of active equity funds outperforming their passive peers in the 12 months to June of this year, according to Morningstar’s Active/Passive Barometer. which tracks the performance of 30,000 European domiciled funds with assets of €7 trillion (£6 trillion).
Active and passive: the differences
An active fund allocates capital with the goal of outperforming an underlying index. This can be achieved by properly investing in the constituents of the underlying index which are increasing in value while avoiding those which are decreasing in value.
A passive fund, on the other hand, simply tracks the index rather than picking individual stocks or bonds. They’re not trying to outperform the index they’re tracking; they aim to equal it.
When choosing investment managers, there are two aspects of expenses to consider. It starts with the explicit cost of running the fund, which is the manager’s annual management fee (AMC) and other ongoing expenses for running the fund, which should be included in the ongoing charges (OCF).
It is also important to consider any hidden or implied costs of executing the investment strategy, such as transaction costs, taxes and other fees. These costs are expected to increase as portfolio turnover increases and will also be affected by the underlying liquidity of the fund’s investments.
The additional time and resources required to determine which parts of the underlying index to overweight/underweight or not own at all ultimately cost time and capital. Therefore, actively managed funds tend to incur higher annual management fees (AMC) and ongoing management fees (OCF) than passive funds.
It is the passive managers who have the edge when it comes to explicit costs. The AMCs of passive managers are typically lower than those of active managers. In recent years, downward pressure on fees has made it possible to find passive UK equity funds with an AMC of less than 10 basis points. Due to the implied market capitalization weighting of these funds, passive managers here also have an implied cost advantage. When the market price of a single share increases, it automatically acquires a greater weight in the passive portfolio, eliminating the need for any trading. It is theoretically possible for passive fund managers to trade only when company shares, indices or fund inflows and outflows require it; this greatly reduces their need to perform day-to-day operations.
When to use passive investments
The question then becomes how and to what extent passive investing should be used in a portfolio if it is believed to have a role to play.
Is passive management better suited to certain asset classes than active management?
There is a wide range of opinions among Financial Advisors. According to Select Wealth Managers, passive management makes more sense in some markets than others. A balanced portfolio can contain both active and passive strategies.
Market characteristics may influence the opportunity for active management. Active management may be effective in some markets where prices are inefficient, if the active manager makes the right decisions. However, the scope of active management may be limited in other markets and the added hurdle of commission income may not be a price worth paying.
In large markets, with high levels of liquidity, high analyst coverage and low transaction costs, passive management may be the best approach.
Equity Investments – The developed markets of the US and Europe are best suited for passive management, with the UK lagging behind slightly due to stamp duty and the limited size of this market. In the UK index, the top 30 stocks represent around 74% of the market capitalisation. Due to reduced liquidity, higher trading costs and reduced analyst coverage in small and emerging markets, passive management may be the least suitable for these markets.
Government bonds, or which US Treasuries are the most liquid, are the best choice for passive management. In addition to traditional government bonds, index-linked bonds are also suitable for passive indexing, although indexes lack the breadth of traditional government bonds.
While liquidity has dried up somewhat in recent years, corporate bond markets are somewhat suited to passive management. Emerging market debt and high yield debt are rarely available in passive form. Markets in these areas are inherently illiquid and difficult to track, making tracking errors and tracking costs likely to be high, making passive management difficult.
It is still a popular choice to invest in actively managed funds, particularly when managers have demonstrated their ability to add value to the account after accounting for the additional fees investors incur. Active managers may outperform passive managers, but proper due diligence must be performed to identify managers with a robust process and proven track record.
Passive management makes sense, especially for those looking to cut costs. While passive investing isn’t right for everyone, some asset classes can benefit from passive investing.
Consider hybrid portfolios, which use passive and active managers together. Active management would be used where pricing is even less efficient to obtain the benefits of passive management in the areas where it is more suitable.
Whether investing in active or passive funds is obviously a matter for you to decide, or you can seek professional help from a regulated advisor.
This article is not personal advice and is for informational purposes only. If you’re not sure whether an investment is right for you, seek advice. The value of investments and the income from them can go down as well as up and you may not get back the amount you originally invested.