The passive vs active investment debate Go compare with our comparison table

The passive vs active investment debate

24 January 2011 / by Paul Dicken

It’s a long-running debate, and is one that is unlikely to ever definitively favour one side or the other: are passive investment funds a better option than actively managed funds?

The debate probably sharpened with the growth of Exchange Traded Funds in the UK. Along with passive or tracker funds, Exchange Traded Funds, known as ETFs, track specific indices, such as the FTSE 100 or S&P 500.

What these funds offer is exposure to the full range of companies that make up an index, or in the least a representative range of the companies in that index. ETFs and passive funds attempt to replicate the performance of the index they track, normally with a large degree of accuracy.

What a passive fund or ETF offers investors

The main two pitches for a passive fund or ETF are the exposure to the performance of an index, which can be a stock market, a sector index (e.g. Global Health and Pharmacy) or commodity index, together with low costs.

The largely passive nature of this type of fund means costs for investors are minimised. The annual management charges on a passive fund can start from 0.15 per cent upwards, but are generally several percentage points lower than an actively managed fund.

The average total expense ratio (TER) – an overall figure that includes management and service costs a fund incurs – for passive funds from Vanguard is 0.23 per cent, giving a very low impact on the return passed on to the investor.

Vanguard, is a leading passive funds provider that began operating in the USA in 1975 and launched its UK business in 2009.

Head of sales at Vanguard UK, Nick Blake, said: “The active/passive debate is one that’s been raging for quite a number of years now and the result every year has been a nil, nil draw. At Vanguard, we run both active and passive funds; we are not coming at it from a religious zeal point of view”

What the data shows

Blake says research shows that in many cases an index fund generates a better return than a managed fund, which many believe is solely to do with the ability of the fund manager. He says good fund managers fail to beat the index that is the benchmark of a fund or sector because costs are deducted from any return they make over and above the benchmark.

“These good managers wouldn’t have failed to beat the index had it not been for the charges on their funds. It’s not what you get but what you get to keep. We believe it is the level of costs that largely determines the rate of returns rather than the ability of the manager themselves,” he adds.

Vanguard has commissioned research on the number of actively managed funds which deliver a better return than their benchmark. In one report, the authors took three benchmarks and the funds operating in the relevant sectors.

The benchmarks were the FTSE 100 Index of the largest companies on the London Stock Exchange, the FTSE 250 Index which includes medium sized firms and the FTSE Small Cap Index of smaller companies.

In the case of the FTSE 100 Index, over five years 25 per cent of funds outperformed the index, for the FTSE 250 10 per cent of funds outperformed the index, and for the FTSE Small Cap 50 per cent did so.

Does the market matter?

For Blake, passive or tracker funds can be a good option for emerging markets as much as developed markets like the US and UK.

He said a myth is often that investing in an emerging market, such as China or Brazil, requires the expertise of a fund manager to select companies, but data showed the majority of managed funds failed to beat the index for its investment area.

The active option

Perhaps the keyword for actively managed funds is flexibility. While a tracker or passive fund can offer diversity across an index, an active fund can potentially invest across numerous indices and may hold a variety of different assets.

Equally an active fund may disregard a benchmark index completely and take a conviction led approach to selecting a focussed smaller number of shares to invest in.

The antithesis of passive

Schroders fund manager Richard Buxton heads the asset manager’s UK equities team and manages the UK Alpha Plus Fund. He recently described the Alpha Plus fund as the ‘antithesis of a passive fund’.

The fund typically invests in 30 to 40 stocks, seeking out companies believed to be performing well over a three year time horizon with no attempt to track a benchmark. Buxton works with a team of equity analysts to select his holdings in what Schroders call a ‘best ideas’ portfolio.

Actively managed funds may also be designed to pay a level of income, with the potential for capital growth through equity investments, such as the Invesco Perpetual Income fund, the Schroders Income Maximiser fund or the BlackRock UK Income fund.

This type of actively managed fund can focus investment in stocks the management team believe are able to provide a level of income, rather than relying on an income distribution from stocks in an specific index, such as the FTSE UK Equity Income index. This type of fund may also use other active investment strategies such as using futures contracts to try and boost the level of income provided.

There is a wide diversity available in actively managed funds, including ethical funds that actively screen stocks to identify suitable investments or absolute return funds which can be multi asset funds designed to produce a level of return regardless of overall market conditions.

Diversification and costs

Diversification is a key principle for all investing: selecting different assets or investment areas to reduce the risk of only holding assets of one kind or in one type of market.

In the process of asset allocation, both passive funds and active funds can provide ways of gaining exposure to different markets and type of asset, while the charges for active funds vary, an average total expense ratio for European funds put the average level at 1.66 per cent per annum.

Through the Fair Investment ISA and Investment Account, and Self Invested Personal Pension, annual management charges for some funds, such as those in the Select 100, can be lower with cash rebates from fund managers reducing annual costs.

However, the costs for passive or tracker funds will generally be at a lower level to their actively managed counterparts, due to the costs of aspects like more frequent trading and research.

Visit the passive funds section to see more examples of index and tracker funds, while the Fair Investment Select 100 includes a range of actively managed funds, as well as some passive funds.

No news, feature article or comment should be seen as a personal recommendation to invest.

The value of investments and income from them can fall as well as rise and you may not get back the full amount invested. Different types of investment carry different levels of risk and may not be suitable for all investors. Past performance is not a guide to future performance.

Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular investment and should read the investment Factsheet and associated documentation.

If you are in any doubt as to the suitability of a particular investment, both in respect of its objectives and its risk profile, you should seek independent financial advice.

© Fair Investment Company Ltd