Investments in a fund or discretionary portfolio can be active, passive or a blend of the two.
In the case of active fund management, a manager is employed to outperform a benchmark – either a publically available index (eg the FTSE 100), or another target (eg the rate of inflation) – by an agreed percentage.
He or she can do this by researching securities, deciding when to buy and sell them, selecting their weightings in the portfolio and then monitoring the portfolio on an ongoing basis.
Passive offerings, meanwhile, attempt to deliver the same return as an index, or ‘track’ it, rather than trying to outperform it.
With active investments the investor needs to believe, firstly, there are managers out there who can deliver outperformance, or ‘alpha’, over a sustained period of time and, secondly, these managers can be identified in advance.
In these times of lower investment returns, a few extra per cent of return each year can make a significant difference over time.
There are risks, though, that these ‘skilful’ managers won’t deliver any extra performance or, worse still, underperform. In addition, active management is generally more expensive and, in a lower return environment, the higher costs of active management will take up a larger proportion of market returns.
Active funds tend to have higher fees, because active managers need to research companies and sectors in depth and follow the macro-economy, or set up and maintain a quantitative process. Also, their transaction costs will be greater as they buy and sell securities more frequently.
Investors in index trackers will have the opposite beliefs – they don’t believe in skilful managers, or at least they can’t be identified in advance – and are therefore not prepared to pay the higher charges associated with active management.
Types of index tracker
Index trackers will normally be either an exchange traded fund (ETF) or a more traditional open ended investment company (Oeic/unit trust. ETFs are listed on an exchange and are traded and settled like shares.
Within the universe of exchange traded investments there are also exchange-traded commodities/currencies (ETCs) and exchange traded notes (ETNs). ETCs and ETNs are rarely used in the UK though. ETFs, ETCs and ETNs come under the umbrella term exchange traded product (ETP).
As ETFs are listed on an exchange, they can be traded and settled at any time during the trading day. The more traditional index funds (Oeics or unit trusts) can only be traded at one or two points during the trading day.
However, in the case of the UK they do fall under the auspices of the Financial Services Compensation Scheme (FSCS) whereas ETFs do not.
A third difference between traditional index funds and ETFs is the latter have, on average and on a like-for-like basis, lower annual charges, because they are slightly easier and cheaper to run, with less administration.