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It has been debated for many years whether active or passive investment management is better. Although many investors and financial advisers understand the benefits of active management, they may be unclear on passive management’s merits, especially how to use it effectively.
The UK Asset Management Market
According to the Investment Association (IA), the UK’s total assets under management reached £9.4 trillion in 2020. The passive strategies account for 31% of the £9.4 trillion, an increase of one percentage point since 2019.
Active and Passive: The differences
Since the eighteenth century, actively managed investment funds have been the preferred pooled investment vehicle of choice for investors.
Funds that invest actively aim to outperform predetermined underlying indices. The fund manager must invest correctly in the constituent parts of the underlying index that increase in value while avoiding investments in those that decrease.
Vanguard was founded in 1975 by Jack Bogle, who pioneered passive investing (index funds). By replicating the entire index, passive funds avoid the risk of analysts and fund managers picking individual shares or bonds that will perform well or poorly. They aim to achieve the same level of performance as the index they track, not to outperform it.
Costs
When selecting an investment manager, two elements of charges should be considered.
An explicit cost of running the fund is the manager’s annual management charge (AMC) along with other ongoing charges for running the fund, which should be included in the ongoing charges figures (OCF).
As well as explicit costs, you should take into account any implicit or hidden costs associated with executing the investment strategy in the form of transaction costs, taxes, and other charges. Generally, these costs increase with portfolio turnover and are also affected by the liquidity of the investments held by the fund.
AMCs and ongoing charges (OCFs) for actively managed funds are generally higher as the result of the additional time and resources required to determine which parts of the underlying index to overweight or underweight.
The AMCs of passive managers tend to be significantly lower than those of their active counterparts. You can find passive equity funds with an AMC of under 10bps, as downward pressure has intensified on fees in recent years.
Due to the market cap weighting inherent in these funds, passive managers also have an edge when it comes to implicit costs. In a passive portfolio, as the market price of an equity increases, it automatically gains a higher weighting, eliminating the need to trade. Ideally, passive managers only need to trade to account for corporate actions, movement in indices, or inflows and outflows from the funds; greatly reducing the amount of day-to-day trading.
When to use Passive investments
If passive investing has a role to play in a portfolio, how and to what extent should it be used? Are passive management and active management more suited to different asset classes?
The views of Financial Advisers differ. According to Sean Gilbert of Select Wealth Managers, “passive management makes more sense in some markets than others, and a balanced portfolio can contain both active and passive strategies”.
There are certain characteristics of markets that can make active management less desirable. Active management may be effective in some markets when the active manager makes the right choices because they are inefficiently priced. Other markets, however, may have a limited scope for active management, so paying the additional fee may not be worth it.
Market Characteristics
The most advantageous markets for passive management are those with wide breadth, high levels of liquidity, high analyst coverage, and low transaction costs.
Equity Investments – Passive management would be most suitable for US and European equity markets, with the UK slightly behind due to stamp duty and its narrow breadth. Around 74% of the market capitalisation of the UK index is accounted for by the top 30 stocks. Passive management would be least suitable for small-cap and emerging market equities due to their lower liquidity, higher trading costs, and less analyst coverage.
Fixed Income Investments – Government bonds, of which US treasuries are the most liquid, are an obvious choice for passive management. Although index-linked bonds lack the breadth of conventional government bonds, they are also suitable for passive indexing. Although liquidity has dried up somewhat in recent years, corporate bond markets are somewhat suitable for passive management. It is rare to find high-yield and emerging market debt in a passive form. Since these markets are illiquid and difficult to track, tracking errors and tracking costs are likely to be high, making them unsuitable for passive management.
Conclusion
After accounting for additional charges incurred by investors, active management is still a popular choice, particularly for managers who have proven to add value. While active managers can deliver greater returns than passive managers, sufficient due diligence is required to locate managers with a robust process and track record.
Particularly for those who want to keep costs low, passive management is a credible option. In some asset classes, passive investing can have a role to play, although it is not the best solution for everyone.
You may want to consider hybrid portfolios that combine passive and active managers.
Passive management would be used where it is most appropriate, while active management would be used where pricing is less efficient.
The proportion of passive/active funds would clearly be your decision. However, you could seek professional financial advice and have a Regulated Financial Adviser tailor a bespoke portfolio specifically for you.
This article isn’t personal advice, it is designed for investors who understand the risks of investing and that investing in funds isn’t right for everyone. If you’re not sure whether an investment is right for you please seek advice from a regulated financial adviser. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
