The debate over active versus passive investing has been reignited in recent weeks, but experts believe that both styles can offer compelling investment arguments in different areas of the market. 
Last month, the Financial Conduct Authority (FCA) highlighted a number of issues over active funds, finding that passives could offer greater returns than their active counterparts in certain scenarios.
Looking at a £20,000 investment over 20 years both generating the same return (assuming average FTSE All Share growth), the passive investor would earn 24.8 per cent more than the active investor.
Yet, while both styles will draw contrasting opinions from investors, certain areas can lend themselves to one method over the other.
Gaurav Gupta portfolio manager at Thesis Asset Management, said: “The decision to use an active or passive fund can be difficult especially considering how cheap passive funds are – whether an ETF or an index fund – compared to the typical active manager.”
“We believe the decision is based on what type of market exposure we want and whether we have confidence in the manager to add alpha.”
Ben Seager-Scott, director of investment strategy and research at Tilney BestInvest, added: “Within the context of looking at both active and passive instruments, I think it is fair to say there are areas that do lend themselves better to using a passive route, and those that are distinctly not well suited.”
He says that the development of 'advanced beta' strategies such as factor ETFs have made the discussion even more complicated in recent years.
“As a general rule, passives work best in the most liquid and well-covered areas where active managers can struggle to consistently add much value after fees,” he explains
“Historically this has included the likes of large-cap US and UK equities, but areas such as gilts, US Treasuries and physical gold are all areas that a passive route can be more appropriate.”
Looking at US large-caps, passive funds have performed much better than active managers, with less than a third of funds in the IA North America sector (which includes several tracker funds) outperforming the S&P 500 over 10 years.
Over a five-year timeframe this tally worsens with just 24 from a possible 91 eligible funds beating the index.
Performance of index vs sector over 5yrs
Source: FE Analytics
As the above graph shows, the sector has underperformed the benchmark by 18.07 percentage points over the last five years and when extended out to 10 years the sector lags by 30.67 percentage points.
“The US market is notoriously difficult for active managers to outperform,” said Gupta.
“Earlier this year, research by S&P Dow Jones, the index provider, found that 99 per cent of actively managed US equity funds sold in Europe failed to beat the S&P 500 over the past 10 years.”
Mike Deverell, partner & investment manager at Equilibrium AM, said: “In areas such as the US, very few funds (if any) seem to outperform. As a result, we’ve invested largely in a tracker for US exposure.”
“I’m not saying that no US can outperform but whenever we’ve looked at it we’ve rarely found anything has come out that’s convincing.”
He says this is partly due to the nature of the US market, where the largest companies in the S&P 500 have a bigger market capitalisation than the largest companies in the FTSE 100.
As a result, says Deverell, there are there are many analysts dedicated to researching those individual companies and with so many people conducting thorough research it is increasingly difficult for a fund manager to outperform.
Deverell said: “They do quarterly reporting of earnings and there’s very frequent guidance issued about where earnings are going – much more frequent than in some of the other markets.”
“The more information that comes out, then the more efficient the market should be – it’s very difficult to find something that somebody else doesn’t know.”
“That’s probably one of the reason the US tends to favour passive – there’s so many people investing in it and it’s such a huge market with such a lot of information coming out.”
Thesis’ Gupta also uses an S&P 500 index fund for his core exposure to the US, noting that this “will be the driver of returns over the longer term as it is well diversified and has exposure to a blend of styles”.
He says that passive exposure is coupled with an active fund in the lower-risk mandates that focuses on dividend-paying stocks and another investing in higher-risk mandates that centres on high conviction growth ideas.
Gupta says Japan is another market where he uses passives to gain exposure, choosing to gain its large-cap returns from a Nikkei 400 ETF.
Over the past decade, the Nikkei 225 has outperformed the average fund in the IA Japan sector, returning 79.21 per cent and 64.46 per cent respectively.
Performance of index and sector over 10yrs
Source: FE Analytics
Gupta says the Nikkei 400 ETF he uses is similar to a ‘smart beta’ fund as it has some quantitative and qualitative requirements for a stock to be included.
“The index is composed of companies with a high appeal to investors; shareholder friendly management, independent directors, adoption of international accounting standards and reporting in English as well as quantitative criteria such as return on equity and operating profit,” said Gupta.
“We believe that the Nikkei 400 index gives us a well-diversified exposure to Japan, whilst ensuring we hold the quality companies we would expect from an active portfolio.”
Over the past five years, however, the average IA Japan sector fund has beaten the Nikkei 225 by 1.7 percentage points.
Equilibrium’s Deverell said: “Japan is one of those like the emerging markets that has gone through lots of cycles but essentially gone nowhere for quite a long time so following the index you wouldn’t have done very much.”
Investors need an active manager who is able to add value when the market is going up and protect your money when they’re going down in areas such as Japan, he says.
Away from equities, another area passive strategies have tended to outperform is in the gilts market, with government bonds shooting the lights out in 2016.
Performance of sector versus benchmark in 2016
Source: FE Analytics
While the IA UK gilts sector is ahead of the benchmark Barclays Sterling Gilts index on the year-to-date by 25 basis points, Equilibrium’s Deverell says fees mean the performance difference is negligible.
“When we hold gilts we use passives and frankly it’s very difficult for anybody to add value,” the market commentator said, adding that he uses an index-linked gilt fund for his exposure to the asset class.
“Certainly in a gilt fund you are buying bonds from one issuer the only call you are making is whether you go longer or shorter dated in essence.”
“If you’re charging even half a per cent when you can get a tracker at 0.1 [per cent] there’s a big difference to make up from not a lot you can do.”
“If you go into something like corporate bonds you might want to go active and have someone actually looking and that’s somewhere you might see some more inefficiencies, but you can’t really do that with a gilt – a gilt is a gilt.”