Investment Trusts – Active or Passive: What’s Best for You?

June 20, 2013

Investment Trusts – Active or Passive: What’s Best for You?

There has been a lot of argument over the years as to whether an active investment strategy is better than a passive strategy.  Before deciding which is best for their individual situation and investment objectives, an investor should understand the difference between the two types of fund investment strategy and the impact they may have upon potential returns made.

What is Active Management?

When an investor invests in an actively managed investment fund, whether within a unit trust or open ended investment company (OEIC) or investment trust, he gives the power of all investment decisions – what shares and assets to buy and sell – to a professional investment manager. This manager will use the access he has to research reports, markets, brokers, and companies to assess markets and individual investment opportunity. He may use the services of analysts to measure the future prospects of companies in which he is considering placing investors’ money, and also visit those companies himself.

The objective of active fund management is to beat the returns made on a benchmark index or market. For example, an actively managed UK blue chip stock market fund may have the objective of beating the performance of the FTSE 100 index.

More generalist investment funds will be able to move money from one region or market to another as the fund manager deems fit, again aiming to maximise the returns on their investors’ money.

What is passive management?

Where active fund management seeks to beat a benchmark index or sector passively managed funds seek to replicate an index or sector, neither beating the underlying benchmark nor underperforming it.

Shares held within a passively managed fund are rebalanced according to the performance of individual stocks within an index, usually being done so by electronic means.

What this means for the investor

Actively managed funds give the investor the opportunity to beat a benchmark index, whereas passively managed funds will only track an index. Active fund managers are able to react to changing market conditions, buying and selling shares as they see fit. This means that in falling markets managers could take the decision to sell quickly and remove downside risk.

Passively managed funds are cheaper than actively managed funds, as they don’t suffer the same turnover of stock or interaction by fund managers. However, neither can a passive fund be ‘out of the market’ when that market is falling: the whole idea behind a passive fund is for it to replicate the movement of the market.

For those investors seeking to beat the returns given by a certain index or sector, it might be assumed that actively managed funds would be worth the extra cost. However, this isn’t always the case.

Active v Passive Performance

The availability of passive funds has increased markedly over the last few years, particularly with the development of exchange traded funds (ETFs) that trade on the stock exchange and have made access to passive funds far easier. Part of this growth has been fuelled by their popularity, produced by the poor performance of active funds.

The assumption by investors that buying active funds will produce better performance seems to be floored. For example, according to comparisons between the IMA All Companies sector of active funds and the FTSE All share Index (the benchmark for this peer group of funds), 70% of the funds within the IMA All companies sector underperformed its benchmark index Over five years, the average fund growth within the sector has been just 3.7% per year compared with index growth of over 9%.

So, it would appear that investors would do well to avoid actively managed funds. However, whilst 70% underperformed the index it does mean that 30% outperformed it. For those investors that picked the right funds for their investment, their returns were greater than they would have been by simply investing in a passive fund.

What causes such poor average performance of active funds?

While poor investment decisions are certainly a contributor to poor performance, one of the key factors is the annual management charges that are levied on investors by actively managed funds. That charge averages around 1.67%, and is levied whether or not the fund makes money.

A loss of 2% by an actively managed fund almost doubles when the fund management charge is added. That’s a big downside effect for actively managed funds to take into account.

What is best for you: active or passive?

The choice for an investor really comes down to the choice of fund manager. With nearly a third of fund managers beating their benchmark, investing in the right fund can produce excellent above average returns. However, selecting the right fund manager will require a certain amount of research and active management by the investor himself: something that he may wish to avoid (hence the decision to invest in funds, rather than individual shares).

Where expert knowledge is required, such as property funds, or funds that invest in smaller company shares or in particular geographic regions, then actively managed funds, where the fund managers are experienced in these specialist areas, may have a greater degree of success across the average performing fund. But for investors who want to replicate a particular stock market index, then investment in an appropriate passively managed investment trust or ETF will benefit from ease of investment and a lower total expense ratio.