Active or passive? It’s a balancing act
A mix of the two may help you get the best returns, says James Connington
Buying shares thorugh funds is the default for most personal investors, who don’t have the time or know-how to maintain a portfolio on individual companies. They usually have the option of actively managed funds, where a manager chooses which shares to buy, or passively managed, where investments are made according to the weightings of an index, such as the FTSE All Share.
Active funds tend to levy higher fees and there’s a debate about which is better for investors in the long run. Active managers with the best records can boast they have beaten passive funds over many years, easily justifying their higher charges, while critics say investors cannot know which active funds will achieve this, and that most won’t.
Something almost all agree on is that paying active fund charges for passive fund performance is the worst of both worlds. Funds that do this have been dubbed “closet” trackers. This is an active fund that behaves as a passive fund, but for the much higher fees associated with active investing.
This normally occurs when a fund manager buys too many companies in the same proportions as the index.
Adam Laird, head of passive investments at broker Hargreaves Lansdown, said: “Active managers charge higher fees because they offer the chance of outperformance. Managers can stray from the index, in the hunt for undervalued opportunities. Closet trackers hug closely to their index but charge the higher fees of an active manager.”
Identifying a closet tracker
Figuring out if a fund is a closet tracker requires detective work, as it’s not in the fund’s interest to make it obvious to potential investors.
Mr Laird said: “You need the fund’s ‘active share’ – the percentage of a fund which is different to its benchmark. If a fund’s active share is less than 25pc, you’ve probably got a tracker. Many closet trackers don’t publish these figures, but you can find a lot from a fund’s factsheet.”
He suggested looking at the top holdings of a fund, to see if they are the same as the index. “Look at a performance chart – it’s a warning sign if the fund is performing in line with the index over time.”
If you identify a closet tracker but still want exposure to the sector, look for other actively managed funds in the sector and apply the same methodology to check they don’t fall into the trap too. If there are no funds offering the level of performance required to justify the fees, gaining exposure through a cheap index tracker may be the best option.
How much is too much when it comes to fees?
The goal of any investor should be to minimise fees as they can eat into returns over the long run. There needs to be a good reason to pay more than 0.9pc as a total charge (look at the OCF or ongoing charge figure). A top fund manager with a consistent record of outperforming the benchmark index over a long time horizon may be justified in charging more.
The case for active investing and identifying a good manager
The active versus passive investing debate has raged for years, although the majority of investors will hold both passive and active investments.
Tom Stevenson, investment director for personal investing at investment and pensions provider Fidelity, said: “You can believe in the value of fundamental, research-based stock-picking without shunning the passive approach completely. One solution is to build a diverse portfolio that combines a core of passive funds, to provide cheap market access, with a group of satellite active funds to add potential for outperformance.”
Mr Stevenson said investors should look for managers who consistently outperform the wider market. “A good starting point is a quantitative approach to identify evidence of repeatable manager skill. That will include looking at how a portfolio is constructed, performance over different time periods, what has contributed to performance in the past and in different market conditions, relative performance, consistency of ranking against peers, and other statistical measures.”
But there were more qualitative elements to consider, such as if the manager has a well-resourced team, their philosophy and ability to handle information.
Investing platforms – the websites through which investors buy funds – generally offer guides, analysis and tip lists. “Markets aren’t always completely efficient... not all investments are priced fairly. So there are opportunities for active investors to exploit irrational peaks of optimism and pessimism to buy shares when they’re undervalued and sell them when they become overpriced,” said Mr Stevenson.
A case for passive investment
Passive investment options, which include tracker funds and exchange traded funds (ETFs), have become increasingly popular.
According to Mr Laird, this is due to the simplicity and cost of such investments. He said: “Over time your fund should mirror the rises and falls of the index – you won’t outperform but nor should you substantially underperform. This makes tracker funds easy to monitor.
“They follow the rules of the index, which dictate what they invest in. Tracker funds don’t need to hire teams of analysts on the lookout for new opportunities to outperform.”
For most investors, passive investing is the easiest and cheapest route, although they need to properly build and manage a portfolio, unless they buy a pre-packaged one.
Mr Laird said the most successful investors often don’t stick to one style but blend different funds to suit their circumstances. The efficacy of active and passive investments depends on the market. Passive funds work better in more developed markets, as active managers struggle to find hidden gems.
Mr Laird said: “The US is a great example of this – the world’s largest market is very well researched, it’s hard for a manager to find cheap opportunities and invest in them before others. Gilts are another good example – with interest rates so low, it’s hard for an active manager to add much value and justify their fees. But there are areas that suit active managers, like smaller companies. These can be underresearched and difficult to trade – meaning lots of value for the right active manager.”
‘It’s a warning sign if the fund performs in line with the index’