Active vs passive investing

When you hear about types of funds, two words come up time and again: active and passive. But what are they?

Passive funds

Passive funds track a stock market index (such as the FTSE 100), and are sometimes called ‘trackers’. They invest in the same companies, in the same proportions. So, for example, if BP or HSBC represent 6% of the FTSE 100 each, a passive fund tracking the index will have the same companies in the same amount.

Because they are simply copying an index, by definition they will never beat that index. But they are, by and large cheaper than an active fund (not all are though so you do have to look carefully). For example, the Fidelity Index UK, which tracks the FTSE All Share Index, costs just 0.06%* per annum. So for every £1,000 you invest, it costs you 60p per year.

Active funds

Active funds and their fund managers aim to outperform their index. To do this, the fund manager will research the stock market to identify and invest only in those companies that, in their opinion, are likely to best. The fund manager is not forced to stay invested at all times, nor do they have to buy companies just because they are in the index.

Because someone is actively managing the portfolio, active funds tend to be more expensive – because you are paying for the fund manager expertise. Fidelity Special Values, a UK equity fund that is Elite Rated, has an ongoing cost of 1.05%*, for example. So for every £1,000 you invest in this fund, it costs you £10.50 per year. That’s a big difference.

Does cost matter?

The debate around active vs passive funds is always pretty lively and has become more so in recent years as investors have focused more on cost. As a result, passive funds have gained in popularity.

Charges are indeed important. There is no point paying over the odds for something and we would always advocate shopping around. But cheapest isn’t always best and we believe performance after charges is what counts.

Indeed, we have run the numbers looking at outperformance vs costs of all equity funds over the past five years** and there is no correlation whatsoever – until a fund costs more than 2.25% per annum that is. Then it is easy to see that costs are eating away at returns. But these are few and far between.

If 20 years of fund research experience has taught us anything, it is that the search for excellence in fund management can be very rewarding for investors. That’s why we launched FundCalibre.

The first part of our process is to put fund performance numbers into AlphaQuest, our proprietary screening tool. This strips out the effects of stock market movements and shows us what value (if any) a fund manager has added and how consistently they have added that value. It then looks at the probability of that manager adding value in the next 12 months.

Only if a fund passes this screen will we meet the manager and take the fund on to the next stage of our ratings process.

Take our two Fidelity fund examples again. If we looked at cost alone it would be a no-brainer. The Fidelity Index UK wins hands down. But let’s look at performance after charges in the table below.

FundPerformance after charges over one year***Performance after charges over three years***Performance after charges over five years***Performance after charges over 10 years***
Fidelity Index UK6.14%33.96%36.00%179.78%
Fidelity Special Values5.44%47.13%61.82%312.89%

While the passive fund slightly outperforms over one year, the active fund has done much better over three, five and ten years.

Over the past 10 years £1,000 invested in the Fidelity Index UK fund has grown to be worth £2,797.78***, while the same £1,000 invested in Fidelity Special Values is worth £4,128.88***. Time to rethink your choice of investment?

These figures are after costs have been deducted and we think they show perfectly the difference good active management can make to investor wealth.

Now, some may argue that Fidelity Special Values is an investment trust and it can use gearing to enhance returns. This is true – but gearing can also mean the trust can fall more in value, so the manager still has to get stock selection right.

But just to reiterate the point, take Elite Rated JOHCM UK Dynamic, which cannot use gearing. It has an ongoing annual charge of 0.81%* and a performance fee – so again not cheap.

Over the same time period the results are similar though:

FundPerformance after charges over one year***Performance after charges over three years***Performance after charges over five years***Performance after charges over 10 years***
JOHCM UK Dynamic2.78%41.63%41.40%273.32%

Over the past decade it has turned £1,000 into £3,733.24*** – almost £1,000 more than the tracker.

Finding good active managers

Now, we’re not saying finding managers who can consistently outperform their index is easy. They are only human after all and even the best have bad periods. Without the aide of a crystal ball, they will inevitably get some calls wrong.

And, as we rightly see and hear all the time when discussing investment funds, ‘past performance is not a guide to future returns’.

But it is possible to analyse a fund’s performance, strip out the returns attributable to the market, and gain a better understanding of which managers have the skills to outperform in different circumstances and why.

By doing this you can increase the chances of achieving better returns than the stock market.

*Source: FE Analytics, five years to 28 January 2019
**Source: FE Analytics, 11 April 2019
***Source: FE Analytics, total returns in sterling to 10 April 2019

The views of the author and any people interviewed are their own and do not constitute financial advice. However the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions. Before you make any investment decision make sure you’re comfortable and fully understand the risks. If you invest in fund or trust make sure you know what specific risks they’re exposed to. Past performance is not a reliable guide to future returns. Remember all investments can fall in value as well as rise, so you could make a loss.