InvestmentsFeb 16 2023

In defence of active funds

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In defence of active funds
(FT Money)

There have been many fads that have come and gone since 2008; Pokemon Go, Marie Kondo, short fringes.

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.