Investing: Active or Passive?

The merits of active and passive investment have been debated for years, an average of 35 per cent of active equity funds outperformed their passive peer in the 12 months to June this year, according to Morningstar’s Active/Passive Barometer, which tracks the performance of 30,000 Europe-domiciled funds running €7tn (£6tn) in assets.

Active and Passive: The differences

An active fund allocates capital with the aim of outperforming an underlying index. This can be achieved by investing correctly in the constituent parts of the underlying index that are increasing in value while avoiding those that are decreasing in value.

A passive fund, on the other hand, simply replicates the index rather than picking individual stocks or bonds. They are not trying to outperform the index they are tracking; they aim to match it.

Costs

When choosing investment managers, there are two aspects of charges to consider. It begins with the explicit cost of running the fund, which is represented by the manager's annual management charge (AMC) and other ongoing charges for operating the fund, which should be included in ongoing charges (OCF).

It is also important to consider any implicit or hidden costs of executing the investment strategy, such as transaction costs, taxes, and other fees. It is expected that these costs will 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 to not own at all, ultimately costs time and capital. Therefore, actively managed funds tend to incur higher annual management charges (AMCs) and ongoing management charges (OCFs) than passive funds.

It is passive managers who have the edge when it comes to explicit costs. Passive managers' AMCs 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 under 10bps. Because of the market cap weighting that is implicit in these funds, passive managers also have the edge here in terms of implicit costs. When the market price of an individual equity rises, it automatically gains a higher weight in the passive portfolio, eliminating the need for any trading. It is theoretically possible for passive fund managers to trade only when corporate actions, indices, or inflows and outflows from funds require them to do so; this greatly reduces their need to perform day-to-day trading.

When to use Passive investments

The question then becomes how and to what extent passive investment should be used in a portfolio if you believe it has a role to play.

Is passive management more suited to certain asset classes than active management?

There is a wide range of views among Financial Advisers. In Select Wealth Managers' view, passive management makes more sense in some markets than others. A balanced portfolio may contain both active and passive strategies.

Market characteristics may affect whether active management is desirable. It is possible for active management to 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 additional hurdle of active fees may not be a price worth paying.

Market Characteristics

In broad markets, with high liquidity levels, high analyst coverage, and low transaction costs, passive management may be the best approach.

Investments in Equity - The US and European developed markets are the best suited for passive management, with the UK slightly behind due to stamp duty and the narrow breadth of this market. In the UK index, the top 30 stocks account for around 74% of the market capitalization. Because of the reduced liquidity, higher trading costs, and reduced analyst coverage in small-cap and emerging markets, passive management would be the least suitable for these markets.

Government bonds, of which US Treasury bonds 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 the indexes lack the breadth of traditional government bonds.

Although liquidity has dried up somewhat in recent years, corporate bond markets are somewhat suitable for 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 of them difficult.

Conclusion

It is still a popular choice to invest in active management funds, particularly when managers have demonstrated their ability to add value to the account after considering the additional fees incurred by investors. Active managers can deliver higher performance than passive managers, but it is necessary to do sufficient due diligence to locate managers with a robust process and proven track record.

Passive management makes sense, especially for those who are trying to cut costs. Even though passive investing is not right for everyone, certain asset classes may benefit from passive investing.

Consider hybrid portfolios, which use passive and active managers together. Active management would be utilized where pricing is still less efficient to gain the benefits of passive management in the areas where it is most suitable.

Whether to invest in active funds or passive funds is obviously a matter for you to decide, or you can seek professional help from a Regulated Adviser.

This article isn’t personal advice and is only for informational purposes only. If you’re not sure whether an investment is right for you please 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 originally invested.