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Should you be an active or passive investor?

  • 14 February 2020
  • 15 minutes
  • Active and passive investing are often regarded as competing styles of investing.

  • But we regard them as complementary ways of achieving our long-term financial aims.

  • The secret is in understanding where and when each has the potential to add value.

There are many things to consider when it comes to investing your hard-earned money. One of the broader ones is deciding between two different investment styles: should you be active or passive?

As well as not being particularly descriptive, the way the discussion is usually framed tends to imply that one is necessarily “better” than the other, and this can leave investors confused about what decision they should make.

It’s another quandary alongside: which asset classes should you invest in (and how much in each) and what regions should you invest in (and how much in each)? So let’s start with exploring what we mean by active and passive investing.

A simple comparison

In both instances, we are describing how someone invests relative to an index like the FTSE All Share, or some other benchmark that measure the performance of a basket of assets. The following explains this in very simple terms.

We should note here that index funds don’t often match the performance of the index they follow exactly as fees and charges which, are deducted from the fund’s value, reduce the total return.

What does that mean for a passive fund in practice?

If a passive fund is aiming to match the return on an index or other benchmark, the easiest way to do this is to buy every stock or bond listed on the index in the same proportion as it is in the index. So if we take the S&P 500 of US companies, this comprises 505 company names. An S&P500 index fund would therefore hold this same 505 companies, matching the relative proportions of each company with how they are represented in the index.

And that’s it. As the prices of the company shares move up and down, their relative positions will change. But the portfolio’s holdings will move in exactly the same way in exactly the same proportions. The only time someone needs to update the portfolio is when an investor wants to buy or sell units in the fund – which could require buying or selling shares – or when stocks leave or enter the index.

Some funds use a technique called partial replication. This involves slicing and dicing the index by its different characteristics (like industry, company size etc) and picking a portfolio of representative stocks that match the index’s profile.

And for an active fund?

If the job of an active fund manager is to beat the fund’s benchmark, they need to be able to identify those investments that are likely to provide a better return and avoid those that are likely to disappoint.

For funds that invest in company shares they do this by studying company reports and accounts, trying to understand what a company’s peers are doing, and how the company’s industry is likely to fare in the future. Based on this, they buy and sell company shares, balancing the potential returns against the amount of risk a particular investment might carry.

They can’t do all this alone, of course, so many managers are supported by large teams of analysts, whose job it is to have an in depth understanding of a particular industry. And all that costs money.

There's never any guarantee, however, that even the most talented fund manager will pick investments that outperform all the time. It’s therefore important that you understand the conditions in which a particular fund manager is most likely to generate returns in excess of the index and when it’s time to switch to a different one.

Why either/or, when you can have both/and?

Rather than focus on whether you should be using either a passive fund or an active fund, we believe you should focus on when it’s appropriate to use one or the other.

When might you use an active fund?

When markets are falling, or when the values of investments are chopping and changing on a daily basis – called volatility – actively managing a portfolio has the potential to avoid some of the worst-falling assets to focus on those that are not falling so rapidly or so far; or, indeed, are still managing to provide positive returns

There are some asset classes – such as Asia and the emerging market equities – where there is less public knowledge about companies and this can make it harder to create a passive fund to track them.

When might you use a passive fund?

When assets are generally on a rising trend, and are less volatile, passive funds have the potential to offer consistently positive returns at a low cost.

There are some asset classes where it is difficult for active fund managers to consistently outperform the index, such as US and Japanese equities so it can make sense to use passive funds for these asset classes.

And if your top priority is to reduce your fees and trading costs an all-passive portfolio might make sense for you.

Conclusion

Active and passive management are two different but complementary ways of investing. Rather than arguing over whether one style is better than the other we should recognise that both can have a part to play in achieving our long-term financial objectives.

Combining them in a portfolio could give you the benefits of both worlds. Use active managers where you believe you can identify consistent skills, and the low-cost broad exposure provided by passive funds for the rest of the portfolio.

We believe in the power of diversified investing to aim to provide a long-term return appropriate to the level of risk you are prepared to take. So alongside deciding how much you should invest in each asset class, you should also consider whether you want to achieve that exposure via an active or a passive fund.

Rather than focus on whether you should be using either a passive fund or an active fund, we believe you should focus on when it’s appropriate to use one or the other.

Market conditions change all the time, so it often takes an informed eye to decide when and how each discipline adds value, and to know when it is time to switch. Even if you decide to use an active manager you need to constantly consider if they’re still the right manager at this moment in time and whether you need to look more broadly.

And this is what we do in our clients’ portfolios. We constantly monitor the investment and political landscape to understand where future opportunities are likely to come from. We then research fund managers in the same way that fund managers research individual investments. What are their strengths? What are their weaknesses? How stable are they as an organisation? How robust are their risk processes? How do they perform in relation to their peers? How is that segment of the asset management industry likely to fare as a whole? Who is most likely to add value in the medium to longer term?

Remember though, that with all investments, returns are not guaranteed.

Important information

Any views expressed are our in-house views as at the time of publishing.

Eligibility criteria and fees and charges apply at Schroders Personal Wealth.

This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

Forecasts of future performance are not a reliable guide to actual results in the future; neither is past performance a reliable indicator of future results. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed and the investor might not get back their initial investment,

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