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Passive investing: the pros and cons

Written by: Rob Morgan
Active funds employ managers to select the best performing investments while passive investing tracks an index. Rob Morgan of Charles Stanley Direct lists the pros and cons of passive investing.

In contrast to active funds that employ managers to try and select the best performing investments, passive investments or “trackers” simply aim to replicate the performance of an index, say, the FTSE 100, usually by holding all or most of the constituents.

There are pros and cons to both ways of investing. Finding active fund managers whose judgement, experience and well-honed investment techniques generate above-average returns on a consistent basis is the primary goal of research teams for their fund lists.

However, the lower charges associated with passive investing offer an appealing route, especially in areas where active managers struggle to outperform on a regular basis.

The pros of passive investing

The main advantage of passive investing is cost. The annual charges are low – in some cases they can be under 0.1%. That compares to around 0.75% for a typical actively-managed fund. So for investors wishing to minimise the friction of annual charges on returns, passives represent a logical strategy.

If you have older tracker funds in your portfolio it is worth checking the charges. Some older passive funds have relatively high annual costs, sometimes in excess of 1%, which is uncompetitive these days. Investors in these funds should consider alternatives as the relatively high charges will simply be a drag on performance and over the long term could result in poorer returns.

The other main advantage of passives is simplicity. Many investors feel more comfortable with passive funds because they know what they are getting – an investment that aims to follow an index. A large proportion of active fund managers underperform their benchmark, so there is a significant chance of underperforming when choosing the active approach when selecting a fund at random.

Over the long term any passive approach is likely to marginally underperform its benchmark due to charges, however small they are, but the “dispersion” of returns from actively managed funds is much wider.

The difference between good and bad active management over the longer term is marked, especially over long periods, and the investment outcome is far more predictable with a tracker – you should receive similar performance to that of the index.

The cons of passive investing

One important risk of passive investing which I believe often goes unnoticed is concentration. Although markets contain a wide range of companies, they are often concentrated towards the very largest. In some cases, indices are over-exposed to one or a small number of stocks or sectors that have a large impact on performance.

In most developed markets individual stock concentration is not so much of an issue, but you can still find yourself unwittingly skewed towards particular sectors. In the 1990s technology and telecoms stocks became a progressively larger part of the FTSE 100. Index and tracker funds benefited from their growth – that is until their subsequent spectacular decline.

Financials then became a dominant component, and then mining shares featured heavily. The dominant, more fashionable sectors are not necessarily where you would want a large portion of your portfolio invested as they could go on to underperform. So-called “smart beta” funds aim to mitigate this problem by weighting stocks equally, or by using other factors such as value, price momentum or volatility, but there are no guarantees these strategies will lead to market-beating performance.

Another aspect to bear in mind is that because passive funds are insensitive to valuation and fundamental analysis of companies, the more passive money there is in the market the more anomalies there should in theory be for active investors to exploit.

True, many managers do not turn this to their advantage and overcome the higher fees but a significant minority do so consistently and therefore add value for investors in their funds.

Rob Morgan is a pensions and investment analyst at Charles Stanley Direct

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