When you’re investing in the stock market, one important decision you need to make is whether you want your funds to be ‘actively’ or ‘passively’ managed.
Active vs passive fund management, what’s the difference and why choose one over the other?
With actively managed funds, a fund manager selects individual stocks to invest in on your behalf.
Their aim is to provide a return greater than that of an index or other benchmark. They’ll research each stock purchase and look at market conditions, the state of the economy, the political climate, as well as more company specific issues.
Some funds may be very specific either in geography or sector split; others, such as Mixed Asset funds, have limited or no stock selection constraints. With Mixed Asset funds, the fund manager can select from any asset class (eg equities, bonds, commodities) and company in any country if it fits in with the fund’s investment philosophy.
Because of the fund manager’s hands-on involvement in selecting the individual stocks to purchase, actively managed funds incur a higher fee than the alternative passively managed funds. What, you hope, you’re also paying for is their ability to spot economic problems before they happen and react accordingly.
With passively managed funds, a fund manager will select an index (a pre-defined selection of assets) to follow. They’ll then hold stocks in the same companies, in the same proportion, as the index and simply track the changes in the index.
Passive investing gives you a holding in every company on the chosen index. It also requires less hands-on management by the fund manager than actively managed funds so generally incurs a lower fee.
The pros and cons
Recent research shows that only 33%* of all active fund managers outperformed an index in 2011.
Passive funds are also cheaper, there’s been a proliferation in the number of index funds available with the increase in Exchange Traded Funds (ETFs) and, a rise in the appeal of passive investing in general.
Opting for index tracker funds is clearly the most obvious choice isn’t it? Or is it?
Passively tracking funds can, in fact, be the more volatile and therefore higher risk route to take.
An actively managed fund will look to outperform a chosen index in all market conditions. Whilst in a rising market it will generally underperform an index, in a falling market it is unlikely to lose as much as an index.
With fewer constraints on what he/she can select, the active fund manager will try to minimise losses in a downturn by holding assets outside of the index.
On the other hand, with a passive fund there’s a lower turnover of shares so transaction costs are usually lower. There’s also no impact on the performance of the fund if the fund manager changes.
However, it is more difficult to have a diversified portfolio with an index tracker. Larger companies that dominate an index will also have a greater weighting in the fund.
So, which should you choose?
Overall, it will be your investment approach and that of your financial adviser that determines whether you have actively or passively managed funds in your investment portfolio. You could, in fact, do both.
Many believe passive funds are better for wealth accumulation as costs are lower, the amounts invested are less and, in a rising market, they tend to outperform active funds.
The issue is when there’s a decreasing market outlook and larger sums of capital are being invested. Active funds may be your better option.
Are fund managers worth it?
Finding the right fund manager is the key here.
A passive fund will give you all the growth in an index which is almost impossible for a fund manager to replicate. But, conversely, you get the entire drop with an index tracker.
A good active fund with a good fund manager will try and capture as much of a rising market as they can but be flexible enough to provide protection when they think a market has peaked.
Article by Ranjit Virk
* The Telegraph 28 November 2011