Whenever you see industry statistics for the average return of a particular sector of the market, Alan Miller, co-founder and chief investment officer of SCM Private, points out they never allow for the fact that over time many badly performing funds tend to be merged away or closed.
Effectively, he says the performance of many of the worst funds that were available and which were invested in completely vanishes, so the reported ‘average’ performance can be highly inflated.
Mr Miller says: “There will always be periods when in the short to medium term the ‘average’ active fund will do better normally as a result of simply holding more in smaller/medium sized stocks than the large stocks, which dominate most indexes and often lag the performance of smaller/medium sized stocks in rising markets.
“If you asked someone which they would choose: a) to make a likely £100 profit, or b) to make a profit which had an equal chance of being either £50 or £150? I think most people would choose [the first].
The performance of active and passive funds depends on market conditions and the individual fund manager, according to Ben Yearsley, head of investment research at Charles Stanley Direct.
He says passive funds effectively give you guaranteed underperformance of an index, while active depends on the skill of the fund manager. The latter can still deliver underperformance and even more significant underperformance, but they can outperform substantially.
Robin Stoakley, managing director for UK intermediary at Schroders, says investors know largely what they are going to get with a passive investment: performance close to the reference index with a degree of underperformance due mainly to the impact of the ongoing charge.
However, he says due diligence should be undertaken on passive funds before investing as a poorly constructed passive fund can suffer performance deviations greater than planned.
With active investing, Mr Stoakley says the choice of manager is crucial and investors should undertake a degree of research before investing to satisfy themselves that their chosen portfolio manager has a good chance of outperforming.
He says: “A poorly managed active fund will underperform its benchmark and thus a passive fund with the same reference index.”
But Andrew Wilson, head of investment at Towry, says the vast majority of investors, including professionals, are better off going passive in most markets, with at least a core of their exposure. However he says it is useful to have some exposure to active funds as well.