Active or Passive investing: Which one should I pick?

Should I invest in a fund managed by a computer or a human being? It’s a common question for investors although the jury is still out on which approach is best.

Passive, surely that’s just for sloths?

Funds run by computers, known as tracker funds, index funds or passive funds, look attractive because, for the most part, they’re cheap. Some charge as little as 0.06% a year.

They work by simply following the ups and downs of a benchmark such as a stock market index or a basket of assets. Because there’s no human involvement, investors don’t have to worry about a fund manager quitting, having a nervous breakdown, or just calling it wrong.

The major downside of passive investing is that your money tracks an index down as well as up. It tracks all the firms in an index too: you’ll be following the bad as well as the good - there is no place for cherry-picking here! The fund will never beat the index either, in fact after fees you are guaranteed underperformance against the index because of how these funds are structured. But the point is that the closer the fee is to 0, the closer your return will be to the benchmark.

Another consideration is that an index may be concentrated in certain sectors or geographies and is not as diverse as you may think. For example, the FTSE 100 contains a lot of mining and oil firms while the S&P 500 is dominated by big tech companies such as Amazon and Google. Furthermore, the FTSE indices are associated with the UK, but the FTSE 100 is actually more of a global index because many of the stocks in this index are of large global companies. Therefore the FTSE 100 really tracks the global economy, more so than that of the UK.

Active, isn’t that just waste of money?

With human-managed funds or ‘active’ funds, some of these problems can be avoided. A good active manager picks only the best stocks, bonds, or other investments, thereby beating the returns from a benchmark index. In a downturn, the manager can also retreat to more resilient assets in the hope of lessening losses.

Traditionally investors paid higher fees for active than passive management, even if the human touch resulted in mistakes or failure to beat the benchmark. In the worst case, the active manager would pick a balance of investments which was very similar to the benchmark index which left the investor paying high fees for a ‘closet’ index (passive) fund. To sort the true active managers from the fake ones, look at the active share. This tends to be buried in fund prospectus but you can sometimes find it on the fund factsheet as well.

In recent years though, the disparity between active and passive fees has shifted. A lot of active funds are working hard to reduce fees - some, such as Royal London UK Equity and LF Majedie UK Equity now charge less than 0.5%, according to data provider Morningstar. In contrast, some specialist Passive funds, such as Close FTSE TechMark or Pictet-Russia Index, can charge 1% or more, says Morningstar.

So which option is best for you?

If you choose the path of least resistance and go passive, then the key to success is to pick the cheapest fund which tracks its index most accurately. The fund’s factsheet will display its fees and ‘tracking error’ (the lower, the better) so go compare! As always, the devil is in the detail.

Active investing requires a bit more research to identify the best funds for you, or alternatively you can find someone to help you. You’ll need to occasionally monitor your investments too. Fees can be higher, but the key here is to look at returns AFTER fees which will show if the active manager is producing superior returns over time (in other words – if they are worth your while, and cash).

Another solution to the either/or issue is to have a combination of both. This is because active and passive funds can do better in different areas. For example, active managers can add value in less-researched sectors such as emerging markets and small company focused sectors. In contrast, passive funds have tended to outperform their active peers in the US, which is known as one of the most efficient markets. These aren’t hard and fast rules, the important thing is to understand what each fund is trying to achieve and pick those most aligned with your goals, ethics, time horizon and risk tolerance (also known as being cool under pressure).

Whichever path you choose ultimately, it’s better to be in the market than not at all (assuming you have paid off your debts). active or passive, your money will likely do better long term than in a bank account (more on that in another post).

Date of publication: 30th June 2020