The merits of active and passive investing have been debated for years. On average, 35% of active equity funds outperformed their passive counterpart in the 12 months ending June this year, according to Morningstar’s Asset/Liability Barometer, which tracks the performance of 30,000 European-domiciled funds managing €7 billion (£6 billion) in assets.
Active and passive: the differences
An active fund allocates capital with the aim of outperforming an underlying index. This can be achieved by investing correctly in the constituent parts of the underlying index that are rising in value while avoiding those that are falling in value.
A passive fund, on the other hand, simply replicates the index rather than choosing individual stocks or bonds. They are not trying to outperform the index they are tracking; they aim to equal it.
When choosing investment managers, there are two aspects of fees to consider. This starts with the explicit cost of running the fund, which is represented by the manager’s annual management fee (AMC) and other ongoing charges related to running the fund, which should be included in the ongoing charges (OCF).
It is also important to take into account any implicit or hidden costs of executing the investment strategy, such as transaction costs, taxes and other fees. These costs are expected to increase as portfolio turnover increases and will also be affected by the underlying liquidity of the fund’s investments.
The additional time and resources required to determine which parts of the underlying index to overweight/underweight or not to hold at all ultimately costs time and capital. Therefore, actively managed funds tend to incur higher annual management fees (AMC) and ongoing management fees (OCF) than passive funds.
Passive managers have the advantage when it comes to explicit costs. The AMCs of passive managers are generally lower than those of active managers. In recent years, downward pressure on fees has resulted in finding passive UK equity funds with an AMC of less than 10 basis points. Due to the market capitalization weighting that is implicit in these funds, passive managers also have an implicit cost advantage here. When the market price of an individual stock increases, it automatically gains a higher weight in the passive portfolio, eliminating the need for any trading. It is theoretically possible for passive fund managers to trade only when corporate actions, indices, or cash inflows and outflows require it; this drastically reduces their need for daily transactions.
When to use passive investments
The question then becomes how and to what extent passive investing should be used in a portfolio if you believe it has a role to play.
Is passive management better suited to certain asset classes than active management?
There is a wide range of views among financial advisors. According to Select Wealth Managers, passive management makes more sense in some markets than others. A balanced portfolio can contain both active and passive strategies.
Market characteristics can determine whether active management is desirable. Active management may be effective in some markets where prices are inefficient, if the active manager makes the right decisions. However, the reach of active management may be limited in other markets and the added hurdle of active fees may not be a price worth paying.
In large markets, with high levels of liquidity, high analyst coverage and low transaction costs, passive management may be the best approach.
Equity investments – US and European developed markets are best suited for passive management, with the UK lagging slightly due to stamp duty and the tightness of this market. In the UK index, the top 30 stocks represent around 74% of market capitalization. Due to reduced liquidity, higher trading costs and reduced analyst coverage in small cap and emerging markets, passive management would be the least suitable for these markets.
Government bonds, of which US Treasury bonds are the most liquid, are the best choice for passive management. In addition to traditional government bonds, indexed bonds are also suitable for passive indexing, although indices do not have the breadth of traditional government bonds.
Although liquidity has dried up somewhat in recent years, corporate bond markets tend to lend themselves to passive management. Emerging market debt and high yield debt are rarely available in passive form. Markets in these areas are inherently illiquid and difficult to follow, making tracking errors and tracking costs likely to be high, making it difficult to passively manage them.
Investing in actively managed funds remains a popular choice, particularly when the managers have demonstrated their ability to add value to the account given the additional fees incurred by investors. Active managers can outperform passive managers, but sufficient due diligence is needed to find managers with a robust process and proven track record.
Passive management makes sense, especially for those trying to cut costs. While passive investing isn’t for everyone, certain asset classes can benefit from passive investing.
Consider hybrid portfolios, which use passive and active managers together. Active management would be used where pricing is even less efficient to reap the benefits of passive management in areas where it is most appropriate.
Whether you want to invest in active funds or passive funds is obviously up to you, or you can seek professional help from a regulated adviser.
This article is not personal advice and is for informational purposes only. If you are unsure whether an investment is right for you, please seek advice. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested.
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