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Pros and cons of a passive approach

This article is part of
Guide to Active versus Passive

This can either be achieved by replicating all of the constituents of an index (‘mirroring’, or ‘full replication’), or selecting a limited number of constituents whose performance characteristics would, in combination, be likely to perform in line with the reference index (‘sampling’).

As the passive portfolio is ‘tracking’ the reference index, Robin Stoakley, managing director for UK intermediary at Schroders, says investors should be able to have a high degree of confidence that they will perform broadly ‘in-line’ with the reference index.

But Mr Stoakley adds while the passive portfolio will track the index, the degree of ‘closeness’ will depend on the quality of the program used to manage the portfolio and the efficiency of stock trading.

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While passive portfolio management has become more efficient inherent variances from the chosen index can and do occur, especially where a sampling method is used depending on exceptional performance of individual stocks.

Secondly, he points out charges will be deducted from the portfolio thus guaranteeing that the passive fund will actually underperform its reference index.

Ben Yearsley, head of investment research at Charles Stanley Direct, agrees that the “main negative” of tracker funds is “guaranteed underperformance of the index”, in contrast to active funds which have at least the potential to overperform significantly.

However, he points out that despite the inevitable hit on performance one of the positives of passive funds is their lower price compared to active alternatives.

Charges vary depending on the scale of the fund and manager, and the index that is being tracked. Some trackers, such as the Halifax UK FTSE All-Share Index Tracker, have share classes charging as much as 1.5 per cent, while fees can be as low as 0.1 per cent. C-class fund

Mr Yearsley argues passive fund annual management charges should not be more than about 0.2 per cent, compared with about 0.75 per cent a year for actively managed funds.

Alan Miller, co-founder and chief investment officer of SCM Private, claims the difference between charges for passive and active funds understate the cost benefit of going passive. In fact, he claims after-cost returns are typically lower in active funds on average.

For example, he says a FTSE 100 tracker can be bought for an all-inclusive cost of 0.1 per cent a year compared against about 1.7 per cent a year for an equivalent active fund.

Mr Miller says: “The simple maths is this: most active fund managers make up most of the market so their return before all costs will always be on average close to the market return, but because their charges are much higher, their after cost returns will normally be lower than a passive fund.

“As compared to the market return, the differences between a good and bad passive fund are relatively small whereas the range of returns for an active fund will be colossal.”

He adds one of the great hidden costs of active funds is transaction costs.

He says: “Every time a manager buys or sells a share or a bond there may be substantial taxes, commissions and market maker spread related costs.