Pros and cons of active management

Active management methodologies may include using a specific investment style (such as employing a value or growth bias to stock selection), concentrating the portfolio into a limited number of stocks and concentrating assets into sectors expected to give better returns than the market overall.

The most obvious downside of active management is the inability to reliably predict returns compared to passive peers.

Robin Stoakley, managing director for UK intermediary at Schroders, says: “Good active management can offer performance significantly in excess of the reference benchmark return. But poor active management can underperform the reference benchmark.”

Ben Yearsley, head of investment research at Charles Stanley Direct, says: “The main negative is there are no guarantees about performance, you are wholly reliant on the fund manager or management team on picking the right stocks for the portfolio.”

Another oft-cited downside is the costs associated with active management. Average active fund AMCs are now around 0.75 per cent, compared to passive fund fees which vary but can be as low as 0.1 per cent.

This fee buys expertise that has the potential to lead a fund to stellar returns relative to a benchmark, or at least to returns that meet a specific target and are not simply tied to the fate of an index.

However, Andrew Wilson, head of investment at Towry, warns that very few active managers beat the market and even less are able to do so consistently. Worse still, he says those that do manage to beat the market are usually unforeseeable in advance.

He says: “As investor cash floods in, it can then turn out that their success was driven by luck, their process isn’t scalable, or that this has gone to their heads.”

Of the top quartile of US mutual funds in the decade 2000 to 2010, Mr Wilson points out 79 per cent of them were bottom quartile for at least three of the 10 years.

He says: “How many people would have invested after a good year and then sold after a bottom quartile year?

“Indeed, the very best performing fund of that decade made 18 per cent compound, but the dollar weighted average investor return was minus 8 per cent.

“This was due to poor timing, and is a reminder that the average investor experience is rarely the same as the average fund performance, it is usually considerable worse.”

Alan Miller, co-founder and chief investment officer of SCM Private, conversely says one of the positives of active funds is timing: if the manager gets it right in terms of when to buy or sell the market or individual securities they can preserve capital when the market is going down and reap substantial rewards at any stage of the cycle.

He says active funds should be able to concentrate on perceived inefficiencies or mis-pricing of individual securities to derive higher returns. Qualitative judgements should be made with active funds rather than purely quantitative, he adds.

Mr Miller says it is key for any adviser contemplating active funds for their clients to ask themselves if they trust the management team running the business and assess whether they are money-makers.

But Mr Miller warns advisers should also think about how normally their clients will be paying much greater charges for the manager’s expertise with an active fund than they would pay for passive funds.

On a like-for-like basis, Mr Miller says passive fund charges are normally at least 80 per cent less and there are very few extra trading costs for those trackers that are tied to major indexes whose constituents do not change frequently.

A typical UK equities fund charges 1.5 per cent a year, he claims. Added to this are fund expenses of about 0.2 per cent a year and trading of around 50 per cent of stocks a year, equating to an extra 0.5 per cent, making 2.2 per cent a year overall.

Because the charges are much greater for an active fund and they make up most of the market and therefore constitute the ‘average’ return, Mr Miller warns you normally receive lower performance after costs than with a tracker.