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Active Investment v Passive – Which is Best?

Active Investment v Passive – Which is Best?

With a universe of literally thousands of funds currently available to UK investors from an ever-widening range of fund management groups, the process of fund selection is fraught with potential pitfalls, hence the growing need for professional advice (well, as Independent Financial Advisers we would say that, wouldn’t we?). In terms of returns for investors however, yesterday’s heroes can often be next year’s zeros and the simple fact is that the majority of fund managers fail to beat their respective bench mark or relative index, so is there a case for the use of ‘passive’ investment funds which simply track a given index? Evidence would seem to point towards this, so let’s take a look at the pros and cons of index tracking funds versus active fund management.

Tracker Funds

Tracker funds are a generally low cost way to invest. Most invest in shares, but you can also find trackers that focus on other types of assets, such as bonds or property. In all cases, their aim is to follow the performance of a particular index such as the FTSE 100 rather than be actively managed by a fund manager. You may also hear these funds called ‘passive funds’ or ‘index funds’ and their main features & benefits are

• Low costs - tracker funds do not need the support of a large research team, as their managers won’t be searching for investment opportunities. As a result, trackers tend to cost less than active funds.
• Broad access - trackers will normally invest in most or all of the companies or stocks of their chosen index, so you will have access to a broad range of opportunities.

So far, so good, but funds which track an index also come with potential downsides, typically

• Tracking error - even after charges are taken into account, most trackers will not follow an index perfectly. The gap between a tracker’s performance and the returns from an index is called tracking difference.
• Potential over-exposure: some indices are dominated by just a few stocks or companies. Buying a tracker means you are mirroring this exposure, so if one of these stocks or companies struggles, it could have a significant effect on your investment.
• Falling markets - trackers aim to follow the performance of an index. This means that in difficult conditions when the index falls in value, a tracker will follow it down.

Actively Managed Funds

Last year saw the continuation of a trend that has gained significant momentum over the past decade as investor cash drained out of actively-managed funds and into their passively managed counterparts. Yet the year also saw seismic political changes, prompting some to suggest that heightened political instability in the West, as well as the move away from aggressive quantitative easing by central banks, would feed through into more volatility and differentiation between stock movements, therein providing a fertile backdrop for active managers to demonstrate their value. The question for investors, therefore, is whether they truly believe they have found one of the active fund management superstars for whom it is worth paying higher fees or whether they are just helping pay for an expensive service to help market functionality to the benefit of other investors.
Let’s take a look then at how things have worked in practice over the last five years, from April 2012 to April of this year. For comparison purposes, we’ll examine the costs and returns between HSBC’s FTSE 100 Index Fund during this period and two of its actively managed counterparts which have appeared consistently in Macarthur Denton’s selected UK fund list during the same time frame, namely the Lindsell Train UK Equity Fund and Old Mutual UK Mid Cap Fund.
In terms of charges, unsurprisingly the HSBC fund comes in at by far the cheapest of the three, with a total annual management fee of only 0.43% per annum*. Compare this to the Lindsell Train fund whose total expense ratio plus service fee more than doubles the cost to 1.00% per annum* and the Old Mutual offering which is a further 10% more expensive again at 1.10% per annum* (*Source: Fidelity FundsNetwork, May 2017). In terms of cost then, it’s a bit of a no-brainer, with the HSBC fund taking the cost plaudits but when we take a look at value, the picture takes on a more interesting perspective.
When we examine the respective returns from each fund, an initial investment in the HSBC Index Tracker of £1,000 in April 2012 would today be worth £1,589 after charges, whilst the Lindsell Train fund would have yielded a net return of £2,306 over the same period. Even better, the Old Mutual offering would have almost tripled your investment with a total net amount of £2,905 – an annualised return of almost 24% per annum over the five year period.
So yes, it’s true that most actively managed funds fail to beat their respective benchmark index but those who do will often produce significant out-performance, sometimes in quite spectacular fashion, as the examples above demonstrate. Don’t be lured into selecting investments based purely on cost; investment expertise is worth paying for - if you can find the right fund manager.

This entry was posted on May 15, 2017