The debate surrounding active and passive investing most commonly falls into the spotlight after particularly strong or particularly weak periods of stock market performance. At such times one strategy has generally performed better than the other, giving supporters reason to extol its virtues.
Most recently, actively managed funds have regained some ground lost to passive funds as investors have tried to capitalise on the strong stock market performance of the past few months.
However, there are dangers to concentrating too much on the short term, or on a single data release. Investors would be better served focusing on the long term. In doing so, framing the debate over active and passive investing as one versus the other is irrelevant. Proponents of each must learn to co-exist – there is active investing; there is passive investing; and each has positives and negatives.
Of the £740bn invested in funds almost £70bn is now invested in tracker funds, according to figures released by the Investment Management Association in May 2013. This represents over 9 per cent of the total. The question of active or passive cannot, therefore, be approached as a ‘black and white’ issue. Investors are no longer thinking of it as an either/or decision – they are using active and passive funds together in their portfolios.
This makes a lot of sense. Most investors will be looking to achieve attractive investment returns, with an appropriate level of risk, and at a reasonable cost over the longterm. Combining active and passively managed strategies can help achieve these aims.
Costs are often at the centre of the argument. They are often cited as one of the main reasons for underperformance among active fund managers. There is no denying that passively managed funds are generally cheaper, but to focus purely on cost is not necessarily the correct approach. Investors must also consider the level of returns they are looking to achieve and the amount of risk they are willing to take.
Passively managed investments such as tracker funds offer a degree of certainty. Often investors appreciate the dependability of knowing what to expect from the performance of their investments. Normally, they can be confident a tracker fund will give the return on the index, less costs. This comes with the trade-off that they are likely to underperform the index being tracked, with this effect becoming more pronounced over the long term. Tracker funds also offer no protection in falling markets. By their nature they will tend to fall as much as the market.
Combining a core of passively managed tracker funds with a selection of actively managed alternatives can help add balance to a portfolio. Active fund managers are generally free to select the investments they believe will perform best. They could choose those they believe will perform strongly in a rising market, or those they believe will offer some relative protection if markets fall.
In return for giving up some of the certainty over how their investment might perform, investors could achieve significantly better returns than those available from the index. This will come at a higher cost than simply tracking the index, but many investors do not mind paying a little extra for an actively managed fund where the manager has demonstrated an ability to consistently add value.