Given the vast number of actively managed fund closures in the aftermath of the dotcom crash and credit crisis, the appeal of a low-cost passive alternative that provides broad exposure to equity markets has increased since the boom years of the 1980s and 1990s. Here we take a look at the pros and cons of each approach and examine how investors can take advantage of both to boost returns.
The active approach
Actively managed investment funds are controlled by a manager, or team of managers, who try to beat the wider index through asset allocation and stock-specific decisions.
These are based on wider research by the investment house, company visits and analysis of global economics.
In theory this means that when the manager spots an opportunity in a certain sector where prices are attractive, he or she can buy up lots of assets or sell them if the sector is about to go through a tough time, thus giving them an edge over the wider market.
However, in practice, the variables affecting the movement of asset prices are too many for most investors to predict accurately and some managers tend to get them wrong as often as they get them right.
In fact, the majority of managers get it wrong most of the time. Data from FE Analytics shows that 65 per cent of funds in the UK All Companies sector failed to beat the FTSE All Share index over 10 years while 71 per cent failed over five.
With statistics like this it is easy to see why so many people are avoiding active management.
However, there are a handful of managers who have proved their ability to beat the market time and time again and it is their funds that investors need to look out for.
In the UK All Companies sector alone the likes of Richard Buxton, Nigel Thomas and Tom Dobell have been able to beat the market more often than not in a variety of different conditions over the long-term.
Finding these managers takes some know-how but FE Alpha Manager and FE Crown ratings are designed to highlight those who have consistently outperformed.
The problem is that a manager’s expertise costs money. Higher charges on actively managed funds compared with passive instruments means that managers have to do better than the index just to stand still.
These charges have a greater effect the longer the fund is held because investors miss out on some of the benefits of compounding interest.
The passive approach
Passive funds are run synthetically, using computers to replicate the performance of an index by holding a basket of representative assets from across the market.
While some of the funds are run by an individual manager who oversees the portfolio, the use of automated systems means that costs tend to be much lower.
The average cost of a FTSE tracker fund is around 0.7 per cent while the cost of investing in the average UK All Companies fund is around 1.5 per cent.
"When people hear that the TER is 1.5 or so, they don’t think that the fee will affect their returns all that much," said Vanguard’s Nick Blake.
"But the compound effect over the long-term is alarming. Over 20 years, an annual management charge of around 0.7 per cent will retain more than 80 per cent of total returns, while a charge of 2 per cent will only retain around 65 per cent."
While anyone who invests in these instruments will sacrifice the chance of outperforming the market, they will also protect themself from exposure to a manager who has a poor year.
As fund literature is always keen to point out, past performance is not a guide to future returns and even the most highly rated managers get it wrong.
The drawback is that many trackers and ETFs struggle to replicate their index. For example, the Halifax UK FTSE All Share Index Tracker has lost 4.71 per cent in the last five years compared with a return of 1.93 per cent from the index.
Performance of fund vs index over 5-yrs
Source: FE Analytics
With a tracking error of 9.2 per cent and a TER of 1.5 per cent, it is easy to see why it has fallen so short of its index.
The combined approach
Arguably the most sensible approach is to use both active and passive investments. When investors feel particularly bullish on a given sector or asset class and have the patience to watch it closely, direct exposure via an ETF or tracker fund could offer a cheap way to access the upside.
In addition, holding a diversified portfolio of the industry’s top-rated managers should provide enough of a margin if one or two of them have a poor spell for the others to pick up the slack.