The debate between passive vs active investment management has long been a source of debate for investors who are seeking to optimise their returns. The question of whether or not active fund managers are worth paying for is at the heart of this topic, sparking debate among investors and financial investors alike.
David Bojan, the founder of H Capital, has over 30 years of knowledge and experience in financial advice and investment planning, and tackles this subject below.
Quick jump:
The differences between active and passive investment funds
Why are investors turning to passive investment products?
Investors are increasingly turning to passive investment products such as tracker funds and exchange-traded funds as they seek a low-cost, easy way to invest in the markets.
There are numerous reasons why they are attracting attention. Underperformance by active managers is one reason – only 36% of active managers beat the average passive alternative in 2023 across seven key equity sectors, according to Investment Association data.
That said, it is unreasonable to expect fund managers to outperform every single year. Even the very best managers will likely have a poor year or two out of five, in which case it’s essential the other three or four years make up for that.
Paying for outperformance
Investors typically pay a higher fee to use an active fund or investment trust versus a tracker or ETF as that additional money covers the cost of the fund manager managing the portfolio.
Charges eat into returns over a long period and investors are right to think about switching to a cheaper passive alternative if they aren’t getting the outperformance they are paying for.
The advantages of passive funds
The disadvantages of passive funds
Of course, because it involves a less hands-on approach to investing, passive investing has notable drawbacks and limitations that can make active investing a more enticing approach for some.
The advantages of active funds
The disadvantages of active funds
Can an active manager sustain their success?
Investors should judge active managers over three-plus years as there will be times when the manager's investment style is out of favour, or they go through a bad patch as mentioned earlier.
The key unknown, however, is whether a fund manager can sustain their success over the long term. If they can, even an extra 1% or 2% p.a. of active returns will have a huge positive effect on the portfolio value simply through the power of compounding, if you add that up over decades through to retirement for example.
Investors move out of cash
The past few years have seen outflows from equities into cash, as investors took advantage of higher interest rates on savings accounts.
Rates are, however, trending downwards in anticipation of Central Bank rate reductions later this year. Therefore, more investors are investing in equities again, and some are considering the age-old debate of whether to go passive or active with their fund decisions.
Despite most active managers underperforming, there are still plenty of managers that outperform and demonstrate stock-picking skills which as mentioned earlier makes a huge positive contribution to portfolio returns.
Conclusion
Given a large proportion of active managers don’t beat the markets consistently, passive investments are an easy option for investors willing and able to take a long-term approach.
However, active funds are worth considering for investors seeking faster returns, especially in areas that are less well covered by the investment community, such as “alternative investments” and smaller companies, for instance, where fewer professionals are assessing and analysing businesses. Proprietary research can often uncover opportunities that are not widely acknowledged.
Active fund managers can potentially harness these opportunities for the benefit of their investors. But how do you narrow down the field of the several thousand investments available?
Here is a selection of characteristics we think are worth considering when selecting an active fund. They reflect some of the principles we use when we select funds for ourPreferred Investments List.
What to consider when choosing an active fund:
1. Have a clear and consistent strategy
Understanding the process behind a fund is vital when assessing if, and in what circ*mstances, it might outperform in the future.
For instance, the approach of some managers is more likely to mean outperformance in rising markets. Others tend to protect capital better during less favourable market conditions because they take a more conservative approach.
Whatever the approach, the outperformance and underperformance of active funds tends to be lumpy and taking this into account can help put returns into perspective.
‘Style drift’, a departure from an established approach or philosophy, should be viewed sceptically as it may mean it’s harder to predict whether a fund will do relatively well or poorly going forward.
2. Invest differently to the benchmark
You can only beat the market if you invest differently to the market. If a fund’s portfolio is like the market’s constituents, then it can likely only offer average performance – and probably below average given the generally higher fees of active management.
If you are paying for active management then that is what you should get. By comparing how many holdings an active fund has in common to its benchmark it is possible to establish how ‘different’ it is, and therefore the extent to which it may deviate from it in terms of performance. This is what is known as ‘active share’.
Different doesn’t automatically equal better, though, and outperformance relies on the skill of the fund manager. What you can expect from a fund with a high active share is that performance could deviate significantly from its benchmark – for better or for worse.
This is why even the best active funds inevitably have poor periods and it’s important not to run out of patience too soon. Shorter-term underperformance can be a result of a certain style being out of fashion rather than a lack of ability, so it’s important to try and understand the reasons behind a fund’s performance when deciding to buy or sell.
3. Go for ‘high conviction’ fund management
By holding too many companies in a fund, a manager can ‘dilute’ their best ideas. In general, we think it's best if managers have the courage of their convictions and limit the number of stocks in their portfolio so that each one can contribute meaningfully to returns.
There’s no prescriptive answer to what we consider sensible but for equities, a 40 to 60 holding portfolio is often an appropriate size to balance the need to diversify risk while ensuring the fund is ‘punchy’ enough to be able to generate significant outperformance.
There’s an argument for holding more as the companies in question get smaller, as well as in more cautious areas such as bond funds where numbers of holdings tend to run into the hundreds. This is due to the greater need to mitigate risk and the usually finite life of each of the underlying assets.
4. Ensure you have an appropriate fund size
In general, it’s easier to beat the market with a small amount of money than with a lot.
While investors are undoubtedly attracted to ‘star’ managers and their ‘blockbuster’ funds, there is a lot to be said for funds that stay small and nimble.
They are more likely to be able to trade in and out of their holdings without having an impact on the price because they own a smaller quantity of stock. They are also less likely to run into difficulties of ‘illiquidity’ – not being able to buy or sell a holding in the quantity required.
Investors should be wary of fund management companies that put ‘asset gathering’ before performance – marketing funds as much as possible with little regard to how the strategy can absorb the additional money. Allowing the fund’s size to become too large can compromise the investment process, especially in areas that are less ‘liquid’ such as smaller companies.
It’s sensible to prioritise managers seeking to grow assets sustainably and with a stable, diverse range of investors, with a view to closing the fund to new investment if necessary.
Certain funds can become victims of their own success, rapidly drawing in new investment because of strong performance. In these situations, investors should be sceptical that market-beating returns can be sustained in the longer term and should think about what might unfold if flows into the fund reverse.
This factor isn’t such a problem for investment trusts. They have a fixed pool of capital to invest rather than one that expands or contracts according to investor demand as with unit trust funds. However, they can still grow through new share issuance.
5. Consider the fund management fees
Fund costs and transparency are increasingly in the spotlight, and rightly so. Fund charges can be a significant impediment to investors’ returns so it’s important to consider the charging structure of a fund, as well as its ‘add on’ costs.
Fund managers are now required to state the transaction costs that are charged to their funds – the amount it costs them to buy and sell the underlying investments, on top of the ongoing charges figure (OCF), which covers fund operating costs, including the fund manager's fees for running the portfolio (the annual management charge or AMC, but not any performance fees), along with other costs, such as administration, marketing and regulation.
Past performance is not a guide to future performance and some investments need to be held for the long term.
