Save, make, understand money


BLOG: Why active and index funds are more similar than you think

Written By:

Despite the noises from providers of both active and index funds about which approach is best, the reality is the two strategies are more closely aligned than many investors might think.

A recent study, conducted by an active manager, suggested some three-fifths of UK and European institutional investors expect the rise of low cost passive funds to have a negative impact on shareholder engagement.  To my mind, as ‘forced’ holders of stock, mostly for the long-term, the interests of index funds and the companies they track is very much aligned. Actively engaging with companies helps drive long term returns. As a large index manager we are constantly looking to do this.

That got me thinking about entrenched views of active and passive management approaches. Coming from an investment house that manages both active and index funds on a large scale it is something that I consider a lot.

Many people think indices forever have to slavishly follow the same companies and sectors. The reality is that because of regular rebalancing, they closely reflect what is happening in markets.

Indices evolve owing to the underlying developments taking place in the market, so if an industry sector goes out of favour it will take up less of the index and be replaced by other better performing companies. As such, index funds can perhaps be considered as a form of momentum investing.

With active managers pouring over company accounts, studying macroeconomics and a variety of screening criteria in place to identify the best companies, investors are left with perception that much more work goes into putting an active fund together than a passive one. Index funds are just run by computers right?

Wrong. A lot of hard work goes into the construction of high quality index portfolios –  it is just a different kind of work. A lot of that work goes into making the fund as efficient as possible when managing index changes. For example, when the FTSE All-Share index rebalances, a proactive index team will undertake significant analysis looking at market conditions, focusing on criteria such as the liquidity of the underlying stocks and volatility in the market. Once this research has been undertaken, the fund manager will look at the rebalance on a company-by-company basis and formulate the most effective trading strategies to reflect the changes in the portfolio, the aim being to maximize returns, minimise transaction costs and drive long term value for investors.

So it is not all black and white. Yes you are buying two different styles, but there is a lot more crossover than you might expect.

Dan Attwood (pictured) is proposition manager of index funds at LGIM