In defence of active funds

One of the big ones that seems to have stuck (within personal finance) is the rise and rise of passive funds, which last year made up between a quarter and a third of total retail fund sales in the UK, according to the Pridham Report.

There are many reasons why passive funds have improved the investing landscape for consumers, not least the low fees, the easy access and the impression that they are relatively low risk investments.

But investors should be careful not to think an entirely passive portfolio suits all investment needs.

Savers will need to be more comfortable with the uncomfortable truth that higher returns ultimately require taking bigger risks.

Passive funds are exposed to total market risk, making them very attractive vehicles when investment outcomes are mostly influenced by a common global factor, as explained here by Mohamed El-Erian, president of Queens’ College Cambridge.

In the case of the past decade or so that has been the ultra-loose monetary policy, which has led to one of the biggest financial market booms in living memory.

When interest rates are low, borrowing becomes easier and cheaper, which leads to easy financing and re-financing, leading to more and bigger companies.

This rising tide lifted all asset prices, benefitting almost all tracker holders.

As the passive fund industry developed, more investors and product managers piled in, increasing the downward pressure on fees, making trackers cheaper all round.

However, this investing utopia came to an abrupt end last year after it became clear that the high levels of inflation seen in developed economies were not as transitory as first thought, and Russia invaded Ukraine.

This is not a call to arms for investors to invest solely with active managers, merely a suggestion of all the things to take into account.

All of a sudden, asset prices were buffeted by headwinds, tailwinds and crosswinds, all with different causes, and market performance has been a lot less uniform with global equity and bond markets losing more than $30tn (£24.92tn) in 2022.

One of the issues this will lead to for investors is a renewed importance of understanding their risk tolerance, as the performance gap between low and high-risk investments will start to widen considerably.

Savers will need to be more comfortable with the uncomfortable truth that higher returns ultimately require taking bigger risks over longer time frames.

Understanding performance

While it is true that a number, if not the majority of active funds, underperform their passive counterparts, which is compounded by higher fees, a lot of these comparisons are made on a three to five-year basis, and less often on a 10-year timeframe.

For instance, one of the most popular active funds in the UK, Fundsmith's equity fund, has underperformed the FTSE All World Total Return over the past one and three-year periods.

But the fund has returned 325 per cent since February 2013 according to FE Analytics, compared with the index's 182.4 per cent.

This is not a call to arms for investors to invest solely with active managers, merely a suggestion of all the things to take into account before deciding with what to construct your portfolio.

Sustainability problems

Another problem that is likely to crop up with passive investing is sustainability.

The requirements of ensuring a portfolio aligns with the end investor's sustainability principles are hard.

"This does not come cheap,” says Julia Hobart, a partner in Oliver Wyman’s wealth and asset management practice. 

The level of understanding around the purpose and outcome of an investment, excluding its investment performance, has increased among fund managers, IFAs and investors alike, and the conversations around expectations have grown ever-more complex.

So it is imperative, for some, that a fund manager is paid to sift through the huge amounts of data released by companies and funds to work out if the underlying investments do indeed align with the thematic considerations expected by the investor.

Do your research, or outsource it, start with what you need the money for and when, and prepare to pay if you want anything other than a tracker.

That work cannot currently be done in a passive fund.

Meanwhile, Hobart says “it is much more fun investing with an active manager.”

This isn’t as trite as some may think it is.

From purely anecdotal evidence, the friends and family who have started to come to me for advice on Isas and long-term savings are the ones who started off investing in things like crypto “for a bit of fun”. 

That got them interested in investing, even if they did lose all their initial investment, and a number are now sifting through various Sipp, Isa and robo-advice offerings to work out which will best support their needs – a sensible way to start learning about personal investing in lieu of an appalling lack of coverage in the national curriculum.

As with everything, whether you use passive funds a lot, or a little, or not at all, depends on your individual needs and wants.

An investment portfolio constructed by a 30-year-old saving £200 a month for their retirement will look very different to the £200,000 Sipp held by a 60-year-old.

But no longer should passives be the default option.

So where to go now? Well, do your research, or outsource it, start with what you need the money for and when, and prepare to pay if you want anything other than a tracker.

We have had it good for over a decade, but the next 10 years are going to be trickier.

Sally Hickey is chief reporter of FTAdviser