A debate has been raging for decades as to whether active investing or passive investing is best. This is largely because there is merit and demerit in both, and partly because fund managers will always argue their work has value.
Yet in different scenarios one will get better results than the other, and investor preferences one way or the other essentially come down to individual appetites.
What’s the difference?
As you might expect, an active investment is more work than a passive one. Active investments cost investors more, because someone is actively managing the money, but should return more because they are actively watching out for opportunities and risks.
A passive investment costs a lot less, but because no one is steering it, in may be more vulnerable to market shocks.
However, not all passive investments are equal. In the case of equity deals, the investor researches opportunities, selects a business with prospects and invests, hoping it will fulfil its potential. The management team does all the hard work and, if it succeeds, investors reap the rewards.
While there is no fund manager, there is a management structure directing the business towards its goals. If these goals are met, investors could see a major return.
Investing in the stock market
When it comes to stocks and shares, an active investment is one in which a fund manager controls where the money goes. They decide when and where to plough money in and likewise take it out. This decision is based on the market, company reputations, changes in leadership structures, previous performance and economic ebb and flow.
Good investment managers do their research. They have contacts throughout the industry; they read reports and expert analysis, and they base decisions on informed guesswork. While it’s hard to predict the future, this knowledge bank – at least in theory – gives them an edge.
Fund managers look at individual opportunities and make decisions to invest on a piecemeal basis. The fund is controlled ‘as live’ and its aim is to perform better than a standard index such as the FTSE All Share, which is used as a benchmark.
An actively managed investment can make big returns if the person in control makes the right decisions at the right time.
A passive investment has much less human input. After the money goes in, it will rise and fall with the market in which it is invested. If the market goes up over time then the investment will grow; conversely if the market falls it will shrink.
One major difference between active and passive funds is the relative numbers of each. Currently, there are far more managed funds than unmanaged ones, although in recent times the balance has tipped slightly towards the latter.
All about the money
The involvement of an investment manager makes active investments more expensive for clients, but there is no guarantee that a managed investment will outperform an unmanaged one even before fees are accounted for.
According to Michael Trudeau, a senior investment researcher at Which?, not many active fund managers have been able to outperform market norms on a consistent basis. He points to 2010 analysis from the UK All Companies Sector which shows less than quarter – 24% – beat the FTSE All Share over the previous ten years.
‘Essentially, there’s a strong chance you could end up with a fund that fails to deliver you the return you could get by simply tracking the index with a passive fund,’ writes Mr Trudeau in this blog post on the Which? website.
He adds: ‘One of the biggest drags on this performance is costs. For the privilege of getting an expert fund manager, you have to pay much higher fees than you would with a passive investment fund. The typical ongoing charge figure for an actively managed fund is 0.85%, rising to 1% in many cases; by contrast, passive funds can be held for as little as 0.1%.’
Incidentally, in the US the ratio is even worse. Morningstar’s latest Active–Passive barometer shows only 12% of active US large-cap growth funds were able to surpass their passive counterparts over the last decade.
For many, the solution might be a portfolio that combines elements of both active and passive investing. A new E-Trade survey, cited in this piece on CNBC, shows that six in ten investors preferred this option compared with three in ten who said the same about an exclusively passive option and 8% who preferred a purely active one.
Whether you opt for an active or passive investment will be down to your own appetite and your tolerance for fees and charges. Arguably, equity investments represent the best of both worlds: fewer fees, but nevertheless a skilled set of managers behind the wheel.
SyndicateRoom launched Fund Twenty8, the UK's first passive EIS fund, in autumn 2016.