Q: Many advise putting their money into passive funds, since active funds rarely beat the market. By only investing in passive funds, I’m worried that I am missing out on a lot of opportunities. Is there a case for having a portfolio with both passive and active funds?
Passive funds are valuable in the investors toolkit as they are generally lower-cost and will provide exposure and returns which track an index or a benchmark (e.g. the FTSE100). Whilst passive funds will always slightly underperform the index they are following (as a result of tracking error and management fees), many investors still opt to use them given the unreliability in the performance of active fund managers.
On fees; whilst active funds tend be more expensive than passive, this isn’t always true. On a like for like basis, some passive funds are actually quite expensive for what you get, whilst active funds are reducing their charges to remain competitive. The gap between the two is narrowing, even if on average passive funds are still cheaper.
In my view, higher fees for active funds is only a problem if the net performance (i.e. performance after fees) is worse. Remember that fund performance is usually quoted net on factsheets and fund platforms so make sure that you’re not making unfair comparisons by deducting the fees again.
On performance; whilst it’s fair to say that active funds often don’t beat the market, this is only one side of the coin. Passive funds are guaranteed to never outperform the benchmark, whereas you have a possibility of outperformance with active management.
A good active fund manager will use their experience, expertise and resources to pick what they believe are the best assets in their market and avoid the worst. Of course, all active managers are aiming to beat their benchmark. Importantly, this is true both in the good times and the bad. An active manager will aim to be more resilient than the market when asset values are falling, as well as to gain more than the market when asset values are rising.
Whilst many active funds fail in this objective, that doesn’t mean that they should be excluded entirely. With thousands of active funds available to UK investors, there are plenty to choose from that do perform well, particularly when we’re investing for the long-term.
So, if we’re not ruling out active funds, when’s the best time to use them? There’s no firm rule I can give you on this. What I can do is give you a few scenarios where active or passive funds are potentially more or less useful.
Scenario 1: You’re investing in a saturated market
When I say saturated here, I mean the opposite of narrow. The best example is something like US large- and mega-cap equities, pretty much any company that’s listed in the S&P500 with the likes of Apple, Ford Motor Company, Starbucks, Johnson & Johnson and Goldman Sachs among its constituents. This is a huge market and one in which many investors, fund managers and asset allocators operate. It’s heavily researched, with hundreds of thousands of pairs of eyes looking at the data every single day, looking for investment opportunities.
What this means is that it’s extremely difficult for a fund manager to find an investment opportunity that has been overlooked by other investors. Remember, fund managers outperform when they make a call on an asset that puts them ahead of the market (be it to have a larger position than everyone else if the stock does well, or a smaller position than everyone else if the stock does badly). When markets are highly saturated, they become extremely efficient and the likelihood of there being a gap in information which can be exploited is much lower, making it harder for the fund manager to outperform.
As a result, many asset allocators and investors choose to use passive instruments for the US large-cap market, for example an S&P 500 tracker. The rationale being that there is little chance of outperformance from a fund manager, making the active management fees difficult to justify.
Scenario 2: You’re investing in a specialist market
The definition of ‘narrow’ is subjective, but for the purpose of this article let’s assume it’s the opposite of the above-mentioned ‘saturated’ market. It could be anything from small-cap stocks, a particular sector (e.g. technology funds, healthcare funds, environmental funds etc.) or a higher-risk market such as emerging- or frontier-markets (you can read more about those here) Within these areas, as examples, there is going to be more opportunity to discover under-valued companies or stocks.
Outside of equities, this ‘specialist’ definition could cover areas such as property, bonds or alternative assets (including infrastructure, commodities etc). In these instances, you may be more inclined to use an active fund where the knowledge, experience and resources of a fund manager could help them to find investment opportunities that others may overlook.”
Scenario 3: Timing is tight
Ordinarily your preference might be to use an active fund manager. However, let’s say that there has been an unexpected event that has moved markets and due to time sensitivities you want to make a quick allocation to a certain asset class, region or market in response. As such, you haven’t yet had time to sit down and research the active funds available, and you don’t want to rush in to using an active fund manager that isn’t aligned with what you’re looking for.
In this situation, you may want to consider using a passive fund in the first instance, just to get your capital working. You can then spend the time finding the right active fund for your goals, knowing that you do have exposure to the asset in the meantime.
Scenario 4: You have very specific investment objectives
When I say specific here, this can mean a multitude of things. It could be that you want exposure to one specific country within a region, say Vietnam rather than a general frontier markets fund. It could mean that you wish to exclude certain sectors of the market (e.g. fossil fuels). It could mean that you only wish to invest in companies with female CEOs or that you want to invest in companies that are having a positive impact on societal or environmental measures.
Depending on the nature of your niche, active or passive funds could be more valuable to you.
Passive funds can be an easy way to gain exposure to a niche that is not offered by any (or many) active fund managers, or where it’s clear-cut. Examples here include ‘only investing in X sector’ or ‘Y region’. It’s relatively simple for an algorithm or a computer to implement this type of strategy.
Active funds can be useful when the niche you’re looking for is subjective (e.g. sustainability criteria) or a judgement call is needed.
There is no one-size that fits all
Both active and passive funds can play a role in your portfolio, and with enough conviction you could justify using either in almost any scenario! As always, the important thing is to be clear on what you’re looking for first so that you can clearly consider all of the options, their pros and cons and find a fund that meets your objectives.
On TILLIT, our experts select both passive and active funds across asset classes, regions and sectors. So, whatever you’re looking for, you can find it in our Universe here, with plenty of handy filters to help narrow down your search.
Date of publication: 9th May 2023
The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.
When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.