Investing: Active or Passive?

Investing: Active or Passive?

The merits of both Active and Passive investment management have been debated for many years. Some investors and financial advisers are clear on the benefits of active management but may be unclear on the merits of passive management, especially how to use them effectively as part of a portfolio.

The UK Asset Management Market

According to figures from the Investment Association (IA), total assets under management in the UK reached £9.4 billion in 2020. Passive strategies account for 31% of the £9.4 trillion, a one percentage point increase since 2019.

Active and Passive: The differences

Actively managed investment funds have been the pooled investment vehicle of choice since the eighteenth century and still attract the majority of investors capital today.

Active funds allocate capital with the aim of outperforming a predetermined underlying index. To achieve this, the fund manager needs to correctly invest in the constituent parts of the underlying index that increase in value whilst not investing in the parts that do not.

When Jack Bogle founded Vanguard in 1975 he pioneered a new way of investing – the passive (index) fund. Rather than analysts and fund managers trying to pick individual shares or bonds they think will perform well or poorly, a passive fund simply replicates the whole index. This means they are aiming to give the same level of performance as the index they are tracking, they are not aiming for outperformance.

Costs

There are two elements of charges to consider when selecting investment managers. The first element is the explicit cost of running the fund, in the form of the manager’s annual management charge (AMC) along with other ongoing charges for running the fund, which should be incorporated in the ongoing charges (OCF).

In addition to explicit costs, it is important to consider any implicit or hidden costs of executing the investment strategy in the form of transaction costs, taxes, and other charges. These costs tend to increase as the turnover of the portfolio increases and are also dependent on the underlying liquidity of the investments held by the fund.

The additional time and resources required to determine which parts of the underlying index to overweight/underweight or to not own at all, ultimately costs time and capital which results in annual management charges (AMC) and ongoing charges (OCF) for actively managed funds being higher than their passive counterparts.

Passive managers have the edge in terms of explicit costs. The AMCs of passive managers tend to be significantly lower than the equivalent active managers. It is possible to find passive UK equity funds with an AMC under 10bps, as downward pressure on fees has intensified in recent years. In terms of implicit costs, passive managers also have the edge here due to the nature of the market cap weighting implicit in these funds. As the market price of an individual equity increases, it automatically attains a higher weight within the passive portfolio, alleviating the need for any trading. In theory, passive managers only need to trade to account for corporate actions, movements in indices, or inflows and outflows from the funds; greatly reducing the day-to-day trading necessary to run the fund.

When to use Passive investments

If you take the view that passive investing has a role to play in a client portfolio, the question then is how and to what extent it should be used. Which asset classes are more suited for passive management, and which are more suited for active management?

Different Financial Advisers take different views. For example, Select Wealth state “we take the view that passive management makes more sense in some markets than others and a balanced portfolio can contain both active and passive strategies blended together”.

Markets have certain characteristics that can affect the desirability of active management. Some markets are inefficiently priced meaning that active management could be effective when the active manager makes the right choices, whilst in other markets, the scope for active management may be quite limited and so the additional hurdle of active fees may not be a price worth paying.

Market Characteristics

Passive management makes the most sense in markets with wide breadth, high levels of liquidity, high analyst coverage, and low transaction costs.

Equity Investments - The main developed markets of US and European equity would be the most suited for passive management, with the UK being slightly behind due to the imposition of stamp duty and the narrow breadth of this market. Around 74% of the market capitalisation of the UK index is subsumed by the top 30 stocks. Small-cap and emerging market equities would be the least suitable for passive management due to the reduction in liquidity in these markets, higher trading costs, and lower Analyst coverage.

Fixed Income Investments - The most obvious choice for passive management is the government bond market, of which US treasuries are the most liquid. Index-linked bonds are also suitable for passive indexing, although the indices lack the breath of conventional government bonds. Corporate bond markets are somewhat suitable for passive management, even though liquidity has dried up somewhat in recent years. High yield and emerging market debt are rarely available in passive form. These markets are illiquid and are difficult to track and so tracking errors and tracking costs are likely to be high, making them largely unsuitable for passive management.

Conclusion

Active management is still a popular choice, particularly managers who have demonstrated that they are adding value, after taking into account of the additional charges incurred by investors. The returns active managers can deliver can be far in excess of their passive counterparts but sufficient due diligence is required to locate managers with a robust process and track record to deliver this.

Passive management represents a credible choice and especially those who are focussed on keeping costs down. Although passive is not the right answer for everyone, it does have a role to play in certain asset classes.

You may consider using hybrid portfolios that blend passive managers with active ones. The aim would be to gain the advantages of passive management in areas where it is most suitable, whilst using active management in areas where pricing is still less efficient.

The proportion of passive/active funds would clearly be for you to decide, or you could seek professional Financial Advice and have a Regulated Adviser build a bespoke portfolio based on your individual circumstances and objectives.

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.