Active vs. Passive Investment Strategies


Active vs. Passive Investment Strategies

Outside of the world of financial services there does not seem to be a personality cult for the investment manager, but Neil Woodford could be an exception. However, even the best of the active managers have a digital competitor that in right market conditions can and often has out-performed the recognised stars.

Investment funds can generally be split into two camps, actively managed and tracker funds. Active funds are managed against an objective by a flesh and blood manager who will conduct their process of research and ultimately buy or not buy stocks within their remit. Tracker funds will be bought and sold against a fixed formula, declared at outset and applied rigorously; no hunches or personal weightings allowed.

As a wild generalisation, active funds will have higher management costs, but may do better when times are uncertain, whereas tracker funds will be cheaper to hold and do best when markets are generally rising.

An article in the Telegraph on the 27th June, (http://www.telegraph.co.uk/finance/personalfinance/investing/funds/11700456/Man-vs-machine-How-Neil-Woodford-was-beaten-by-a-computer.html), illustrates the issues, but also adds that of the 70 or so funds in the sector, only 14 have beaten the specific tracker fund. For adviser and investors alike, the active vs. tracker decision is quite complicated as relatively few managers make enough difference to justify the higher management charges. Academic studies both in the UK and the USA have suggested that after you take into account the costs of fees, any variations in performance can be explained by random chance. (http://faculty.chicagobooth.edu/john.cochrane/teaching/35150_advanced_investments/luck%20versus%20skilll%20in%20the%20cross%20section%20of%20mutual%20fund%20returns.pdf).

When faced with the active vs. passive debate, a private investor probably should concentrate on exposure to the market, rather than an academic argument with no ultimate conclusion, but I feel that it is interesting that Warren Buffet, when offering guidance to his executors for his wife’s pension said “My advice to the trustee could not be more simple: put 10pc of the cash in short-term government bonds and 90pc in a very low-cost S&P 500 index fund.” To narrow down the field, he also put: “I suggest Vanguard’s”.

Even within passive funds there are a number of variables to keep a wary eye on. Not all passives are created equally, with very few attempting to match the index by holding a specific proportion of all the components within the relevant index. Most will try to match the index by holding a simplified version of the holdings, or even try to reproduce the index using assets outside of the index or derivative contracts, (known as a synthetic index). As a consequence of the complexity of trying to follow a moving target, all passive funds will have some form of tracking error, meaning they have ‘missed’ the index by a variable amount. One provider, Vanguard, quotes a tracking error on 5 basis points on an S&P 500 fund, but Morningstar quotes an average tracking error of 38 basis points across all index funds, (Tergesen, Anne; Young, Lauren (2004). "Index Funds Aren't All Equal", Business Week).

For the investor, the tracking error and the fund charge represent an uncertainty of return compared to the index. Just as not all passive funds share the same tracking error, the general assumption about the small size of the fund charges does not always hold good. Looking at the FTSE All Share index as the target, The Virgin UK Index Tracking fund has a OCF, (Ongoing Charge Figure), of 1%, whereas the Vanguard FTSE All Share Index fund has an OCF of 0.08%, (www.trustnet.com). To add to the pain for the Virgin fund holder, the fund shows signs of considerable tracking error, the FTSE All Share Index has a 5-year return of 72.6%, the Vanguard fund shows a return of 72.8%, but the Virgin fund shows only 62.9%.

Just as active funds have issues with underperforming managers not justifying their charges, passive funds have issues with poor outcomes compared to the index and variable running costs. 

As the simplest way to maximize your returns from a given investment risk level is to minimize the costs, so a passive fund at an annual management charge of 0.1% or 0.08% will be a better proposition than a similarly targeted fund at 1.0%, even if all other performance was identical.

Some people believe that something that is expensive is automatically much better than something that is cheap. In investments, this is a common fallacy; what matters ultimately is what you are actually buying; the gloss around it is unimportant, whether it comes in a gold envelope with an embossed plastic card or a plain, buff envelope, what it is worth after charges and market movements is all that counts!

Going back to the active verses passives argument, the best funds of either persuasion will outperform the worst, but do you have the tools to select either? Where times are turbulent, academics would suggest a bias towards actives, but no one would suggest selecting these with a pin; using a qualified adviser ought to improve the likely outcome, as there is significant variation between the best and the worst.

If you would like to know more about how we can help you plan and realise your financial goals then contact us at info@martin-redmanpartners.co.uk or call us on 01223 792 196.

The information contained is for guidance only and does not constitute financial advice. It is based on our understanding of UK legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change. Accordingly no responsibility can be assumed by Martin-Redman Partners its officers or employees, for any loss in connection with the content hereof and any such action or inaction.