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One of the most contentious issues in the world of investing is the great “active vs. passive” debate. In short, are investors better off trusting their capital into the hands of a professional investment manager to try and “beat the market”, or are greater returns found in investing in funds which track an index? In this article, our financial planning team here at Cedar House offers some thoughts on this important question.
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Definitions & characteristics
What exactly do we mean by “active” and “passive” investing? Not all funds, investments and assets fit neatly into either one. Yet, broadly speaking, the two can be differentiated as such:
- Goals: active investing seeks to outperform the market by finding opportunities which have been missed or overlooked by other investors. Passive investing assumes that such opportunities, by and large, do not exist and so track market movements instead.
- Core assumptions: active investors tend to believe that investors are irrational. As such, they can make decisions (e.g. buying/selling a stock) which “wiser”, less emotionally driven investors can exploit. Passive investors do not necessarily dispute that investors can be irrational, but assume that developed markets are broadly efficient. Moreover, information is available in real-time to all investors around the world at the same time. So, even if inefficiencies presented themselves, it would be too late to exploit them by the time you knew about them.
- Investment decisions: an active investment manager will regularly choose which stocks to buy and sell within a fund, where investors have pooled their money. They are the key decision-makers. A passive fund, however, does not engage in such “stock picking” but rather follows an index – like the FTSE 100. As such, the index makes the decisions.
Passive investing is relatively new in historical terms. Only in the 1970s did it come to seriously challenge the widespread assumption that active managers could “beat the market”, and that active fund management was the only real option available for those looking to grow a portfolio.
The great debate laid bare
Two core questions come forth within this debate. Firstly, can active fund managers consistently do what they claim they can – i.e. beat the market? Secondly, if they can indeed do this, does it translate into higher real returns for their investor clients? A lot hinges on the answers, since this can hugely impact the growth of your portfolio and your quality of life later in retirement.
Here, it’s important to look at the evidence. One famous piece of research is by Vanguard’s Jack Bogle, which reviewed 355 actively-managed US equity funds between 1970-2005. It found that by 2005 only 132 were still left in existence, with 60 of them beaten by their index equivalent by at least 1%. Out of the 72 remaining, 60 failed to produce more than 1% above their market index. In the end, Bogle only found 9 funds which delivered returns that he deemed were based on skill rather than luck.
In short, it’s possible to find active fund managers who can “beat the market”. Yet it is arguably impossible to discern which ones will eventually be the true winners. A case in point is Neil Woodford, whose Equity Income Fund outperformed the market for years before witnessing millions pouring out of the fund due to bad performance. At its high-point it held £107bn in May 2017, yet by June 2019 this had fallen to £3.7bn. Eventually the fund was suspended and announced its closure in October 2019.
Assuming you can indeed find an outperforming active fund manager, does this naturally lead to higher real returns? One of the other common traits of actively-managed funds is that they tend to come with a higher cost for investors. After all, the fund is employing an active fund manager and possibly a team of researchers. The regular trades (i.e. stock buying/selling) also typically attracts taxes, which are passed on to the investor.
Despite this, there is some evidence that certain actively-managed funds can be worth the extra cost for investors. One research piece by Guggenheim Investments, for instance, suggests that bond funds can perform better under active managers – sometimes beating benchmarks by as much as 57%. Moreover, it’s worth mentioning that certain types of investment are still largely concentrated in actively-managed mutual funds rather than “passive” ETFs (exchange-traded funds). For instance, many ESG funds (i.e. those which promote environmental, societal and governmental progress) are managed currently in this way – although this is changing in 2020.
Conclusion & invitation
The great debate is certainly not settled, and there are good reasons for investors to include active and passive elements within their portfolio – depending on your beliefs, financial goals, investment horizon and overall financial situation. This is where a financial planner can add a lot of value by helping you organise your thoughts regarding your own portfolio, and constructing it in a way which satisfies your objectives and wider investment appetite/philosophy.
Interested in discussing your investments or wider financial plan with an experienced financial adviser? Get in touch today to discuss your financial plan with a member of our team via a free, no-commitment consultation:
020 8366 4400 or firstname.lastname@example.org.