Jenny Lowe investigates the differences between passive and active fund management and asks which is best in the current climate.

In 1973, American economist and writer Burton Malkiel argued that active managers are, on average, unlikely to outperform the market and that passive funds are probably best for investors.

The debate over which style produces better returns for investors over the long term has continued since index-based funds appeared in the mid 1970s. Active managers look for companies they expect to beat the market, while passive investors try to track benchmarks such as the FTSE 100. In general, active management has not been supported by the abundance of research that has been carried out in the field, with the majority of studies showing that passive management is the better approach for investors. There are, however, exceptions.

Sheridan Admans, investment adviser at The Share Centre, explains, ‘On one hand you have passive management, where a fund basically tracks an index such as the FTSE 100, and on the other you have active, where the manager can effectively invest where they see fit. Pick the right active fund and you could rake it in.’

The argument has developed and it is now less about which style reigns supreme and more about how to use them together to maximise the performance of an investor’s overall portfolio.

‘It is not so much a case of one versus the other,’ explains Peter Robertson, head of retail services at Vanguard. ‘It is much more an issue of getting the right mix of sectors and regions.’

Mirror image
A passive management approach involves creating a portfolio that simply mirrors an index, such as the FTSE 100, as opposed to trying to beat it. These funds follow the belief that no traditional fund manager can outperform the index over the long term, therefore making index tracker funds a better option for investors.

The main benefit of using an index-tracking fund is the low cost. Because there is no need for tracker funds to have teams of experts monitoring individual companies and there are no extra costs involved in the regular buying and selling of different shares, they are very cheap to run.

For example, a traditional unit trust or open-ended investment company (OEIC) could charge an initial fee of up to 5 per cent and an annual management fee of around 1.5 per cent of the fund’s value per annum (although it is possible to get a discount or avoid these charges altogether by investing via a fund supermarket). In comparison, tracker funds typically don’t charge an upfront fee and only charge up to 1 per cent per year.

A range of options
When it comes to passively managed products, one of the key things to watch out for is tracking error – the measure of how closely a portfolio follows the index to which it is benchmarked.

You may find, for example, that a regular index-tracking fund has an error margin
of around 0.5 per cent, which means that it is not tracking the index perfectly.

As Manooj Mistry, head of db x-trackers UK, explains, this allows the fund to cover the costs of reinvestment. ‘Regular index-tracking funds buy and sell units in small sizes directly from investors, which means that the fund will always hold an element of cash, because it needs to pay for the proceeds of any redemptions.’

Db X-trackers specialises in providing exchange-traded funds (ETFs). Similar to traditional index funds, ETFs are designed to track a particular exchange or index and allow investors to buy into a range of companies through a single quoted share.

Mistry suggests that ‘ETFs are a building block in a portfolio, giving investors flexibility. It is not a question of just
buying and holding – investors have the opportunity to change the way they invest and be much more dynamic.’
The main reason ETFs are gaining popularity among investors is their low costs. Mistry explains, ‘If there is less activity at fund level on an ETF, then management costs can be kept low. If you look generally at ETFs, they will have a lower management fee compared with a regular index-tracking fund.’

And Tristan Hanson, manager of asset allocation and strategy at Ashburton, believes that ETFs have their place as an active tool. ‘These products can be very useful and are easy to get in and out of, so they are being used actively by investors.’

Exploiting inefficient markets
It can be said with some confidence that index-tracking funds are much more effective in efficient markets, such as the UK and the US, because the transparency of the financial systems makes it harder for active fund managers to seek out bargain stocks that have been overlooked.

But as we emerge from the recent recession, it is the developing markets such as China, India and Brazil that are registering at the top of the ‘where to invest next’ list.

Fund managers argue that it is here that active management comes into play. Chris Wylie, manager of the Iveagh Wealth fund, says, ‘If you asked investors to name the top Japanese equity fund manager, they would have difficulty, whereas in the UK you have names like Neil Woodford and Anthony Bolton that roll off the tongue.’

Active investment management, or stockpicking, allows fund managers more flexibility and the potential for greater returns. Essentially, they are free to pick the winners and stay away from the losers, and as an investor you are relying on their skills to beat the market overall, by picking stocks that outperform the index.

Trackers can only ever provide you with an ‘average’ performance – you’re never going to come out top. So if you are looking for extraordinary growth, then you are tying yourself to an active strategy and, of course, exposing yourself to increased risk. However, it is important to bear in mind that the same fund manager very rarely comes top two years running.

Managers can perform superbly in some market conditions and very badly in others. To make money through market cycles, therefore, investors need to understand what makes the individual managers tick and thereby identify those most likely to perform well in the prevailing market conditions.

If there really is such as thing as stockpicking skill, then it’s likely to be most obvious when the benefits of picking winners are greatest. During the period 2003 to 2007, although markets rose steadily there wasn't so much difference between the best- and worst-performing stocks, and the difference between the tracker fund and the star stockpicker was far less clear.

But when the markets took a turn for the worse, the difference between the best performers and the worst was clear, and active stockpickers were able to move in and out of the affected areas – namely financials.

Hanson points out, ‘Active managers are able to identify the dangers of a bubble and make a judgement as to whether they would be better off out of the sector altogether rather than attempting to stock-pick the inefficiencies. This is easy for an active manager to do, and in the recent crisis those that moved out of financial and retail sectors and into more defensive areas fared best.

He adds, ‘A passive fund, which mirrors the index, would have had exposure to those sectors that were badly affected, and that would have had an impact on the fund’s overall performance.’

Your view of the market
So what’s the conclusion? Essentially, it boils down to an individual’s risk profile and view of the markets. If, for example, you believe that it will be near impossible for an active manager to outperform a market, then you should opt for a passive fund for that section of your portfolio. But, should you want exposure to emerging markets, say, where the value is found on a stockpicking level rather than by replicating an index, then perhaps the active management route would suit you.

Peter Jordan, head of proposition marketing at Skandia, concludes, ‘If you look at how a discretionary manager runs a fund, you find that for particular sections of the portfolio a passive managed fund would be used, but for areas where there is more value to be had, a portion of the portfolio would be in active funds.

‘It is all about putting together funds that will outperform in keeping with the investor’s attitude to risk.’

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