Passive vs. active investment – a phoney war?

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Written by:
02/07/2015
Investors should not necessarily pick one strategy over the other. The real question should be when and how active and passive can be used together.

For years, the relative benefits of active versus passive investment management have been debated – the former referring to funds directly managed by financial professionals, the latter unmanaged vehicles that emulate the movements of a particular index.

Typically, it is argued that active managers offer value through their dedicated research capabilities, and resultant expertise in selecting stocks. Passive proponents retort that passive vehicles offer broad access to markets at a much-reduced cost.

In recent years, there has been a marked shift towards passive vehicles. Part of this is perhaps due to simple cost considerations – most trackers are free to set up, and charge annual fees significantly lower than 1 per cent. Active funds on the other hand can demand upfront fees of up to 5 per cent, and annual charges of over 1.5 per cent.

Mark Dampier of Hargreaves Lansdown believes that the move is more attributable to a growing belief among investors that active managers do not offer better returns than tracker funds.

“The argument that actively managed funds deliver better returns due to superior expertise and resources isn’t consistent with reality,” says Dampier.

This view is supported by a Vanguard Investment Research investigation that concluded “there is little evidence to support the theoretical benefits of active management”.

Some passive advocates believe active management is approaching extinction, and trackers are the future. Others believe they’re a fad.

“While there is recent evidence to suggest passive trackers perform better than active managers, to my mind this is symptomatic of the bull market of recent years,” says Darius McDermott, managing director of Chelsea Financial Services.

“In sluggish periods, or downturns, active will obviously outperform passive.”

The wrong approach

Is one objectively better than the other? Should an investor need to choose between the two? After all, active and passive investment are not necessarily mutually exclusive.

“I think the ‘versus’ debate is something of a red herring,” says James Bateman, head of portfolio management at Fidelity Solutions.

“Both strategies offer a different set of risks, costs and benefits over time. If shrewdly combined in a portfolio, passive and active can work together effectively.”

Tim Cockerill, investment director at stockbroker Rowan Dartington, also believes a combined approach is best.

“I’d be the first to admit that there are some active managers of questionable value out there,” he says.

“However, there are some excellent ones too. There’s no need to stand rigidly on one side of the debate. Just as investors seek to diversify their portfolios according to asset class, investors can diversify according to passive and active strategies.”

Perhaps the real question, then, is when to utilise the two strategies, and how to combine them.

And not or, both not either

“There’s no single correct way to combine passive and active strategies in a portfolio,” says Bateman.

“What’s important is to understand where these approaches work, and why.”

Cockerill likewise notes that different approaches work better for different markets.

“For instance, last year Warren Buffett said the S&P 500 Index Tracker was the best way for overseas investors to invest in US stocks, and I’d agree with his analysis,” says Cockerill.

The success of S&P trackers is due to the efficiency of the Index – large cap US equities are rarely mispriced, so a passive approach that mirrors the movement of the market overall gives investors access to broader growth.

McDermott acknowledges that finding an actively-managed US equity fund which can consistently beat the market is extremely difficult.

“Just last month, another report came out stating that 84% of actively-managed funds invested in US equities failed to beat the S&P 500 over the past year – indeed, it is the market where passives regularly do better,” he says.

For Bateman, passive vehicles work best when an investor aims to secure precise exposure to certain asset classes, such as major equity or fixed income markets – “The wider an index’s reach, the better it will perform,” he says.

On this basis, a tracker is an ideal fit for the FTSE All-Share Index, which covers 1,000 publicly listed companies in the UK. Similarly, the MSCI United Kingdom Index, which includes all large and mid-cap listings in the UK (and stands at 109 constituents as of 2014).

“On the other hand, the same isn’t true of a FTSE 100 tracker, because it’s a polarised market, with investor focus and cash heavily concentrated in the top listings – individual shares are much more likely to outperform that index, meaning active managers can really offer value,” Cockerill continues.

The same logic applies to small caps. Passive investment in the FTSE SmallCap Index, FTSE Fledgling Index and the Alternative Investment Market would at best produce very poor returns, and at worst lose an investor money. However, fund managers equipped with specialist info on listed companies have the potential to pick individual stocks that could deliver significant returns. Emerging markets are likewise best suited to the expertise and dedicated research that active managers can offer.

Bateman notes that synthesis of the two investment strategies is increasingly reflected in investment products. Recently, ‘Smart Beta’ have fused passive and active approaches – such vehicles track the performance of specific assets according to particular targets and attributes, which cannot be emulated through a traditional index strategy.

A notable ‘Smart Beta’ is the S&P US Dividend Aristocrats ETF, which provides exposure to companies in the US that have consecutively increased dividends over the last twenty five years.

“’Smart Beta’ combines some of the best elements of both strategies – the low cost of passive, with some of the analysis and focus that comes from active,” Bateman says.

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