Ask one adviser their preferred investment style and they will say active. Ask another and they will say passive. Both advisers will defend their positions to the death, so as a client how do you make the choice? Well, a little knowledge is always helpful, so here goes.
Passive Investment Style
A passive fund manager aims to closely replicate the performance of an index. For instance, if the fund were based on the FTSE 100, a passive manager would purchase shares in the companies that make up the FTSE 100.
Active Investment Style
An active fund manager aims to outperform the chosen index. Again, using the FTSE 100, an active fund manager would look for companies, similar to those in the index, that they believe are undervalued and have the potential for greater gains.
Is Active Management Worth The Additional Cost ?
Active management sounds great, so what’s the catch? Cost. In-depth research is required to identify companies with the potential for outperformance. An active fund manager could charge up to 1% per year more than a passive manager. That might not sound much, but if you invest £100k today and get a real return of 3%, in 20 years an active fund with a 1.5% charge would return £134,686, whereas a passive fund with a 0.5% charge would return £163,862. That’s a difference of over £29k, so you’ve got to be reasonably confident that an active manager is going to recoup this deficit and make additional gains. Unfortunately, a study of the S&P500 showed that, over the long-term, over 80 percent of active managers across all categories underperformed their respective benchmarks!
Should I Choose Active or Passive Fund Management ?
Active funds are more suited to adventurous investors, because higher risk funds have greater potential to overcome the cost of active management. This doesn’t mean that active funds are more risky than passive funds as the risk rating of a fund is defined by it’s asset allocation (I will cover risk rating and asset allocation in a future article).
We have only touched on the subject of investment syhere, but a good adviser will ensure you understand the different investment approaches and assist you in making an informed choice. They will then select funds whose managers have shown strong and consistent historic performance. Of course, like anyone else, fund managers can change jobs, or lose their edge (see Neil Woodford), so it is essential to review the fund selection on an ongoing basis.