Investing: Active vs Passive

Investing is all about decisions – Where to invest? With Whom? How much risk to take?

But perhaps the most debated investment decision is the question of Active vs Passive funds. An active fund will aim to pick stocks that will outperform the benchmark or index. A passive fund will simply buy the stocks that make up their index, with no ability to use their judgement. Logic suggests the active fund should outperform the passive. They are, after all, making a judgement about what to buy for the sole purpose of adding value, and indeed justifying their higher fees.

Proponents of passive investing believe active fund managers do not consistently outperform their benchmarks – research over the last few years has shown that, on average, active funds consistently underperform their benchmark or index. The argument follows that investing in cheaper funds that simply track the benchmark is a far better long-term strategy.

But while it’s true most active fund managers underperform their benchmark, it’s also true of passive funds. If the passive fund manager is simply replicating the index, then there is no room for outperformance, leaving the only possible outcome an underperformance by the amount of the fees. Passive funds will have a lower degree of risk because the manager is not trying to second-guess the market, but there is an element of guaranteed underperformance.

Cheerleaders for active investment management claim while most underperform the benchmark, some outperform - the point of investment research is to identify those outperformers. As active funds are more likely to underperform, the key to picking a good one is to identify traits – positive and negative. Size can be an issue. The fund could be too small, meaning the fixed costs of running the fund are high as a percentage of its assets, or too large, meaning the manager cannot invest a large weighting in the best ideas without breaking shareholder rules. Sometimes large funds incentivise their managers in the wrong way, by encouraging asset gathering rather than performance. Performance could be affected by a manager going through a crisis of confidence or it could simply be the fees are too high.

There are several positive aspects to focus on. These include ensuring the fund manager has the same investing philosophy as you, such as focusing on total return rather than benchmark comparisons, or ensuring they define risk in the same way. If the manager has a considerable amount of their own wealth invested in the fund, that’s usually a good sign their incentives are aligned with yours.

The key to investing is to pick good funds, active or passive. Only active funds have the ability to outperform the benchmark, but you run the risk of picking an average underperformer.

Craig Davidson

Davidsons IFA