Active investment relies on the skill of either the individual investor or a fund manager to outperform a particular benchmark. The benchmark is usually a well known index (such as the Dow Jones share price index in the United States or the DAX in Germany). Passive investing seeks only to match the rise of the relevant benchmark. The decision needs to be taken no matter if the investment is for a pension or for another financial goal.
The decision of active or passive investing does not only affect wealthy people with spare cash to invest in equity funds. Workers with defined contribution pension plans may be required to pick which fund their money is invested in – with a range of active and passive funds among the choices. Knowing the difference between the two can be crucial in determining the long term returns from the fund. An investor may decide to try to have the best of both worlds by investing in mixture of passive and active funds.
The costs of risk and return
Active managers buy and sell specific company shares in the belief their skill will enable them to outperform the benchmark. A passive fund simply “tracks” benchmark, so they are also known as tracker funds. There is a longstanding debate over the merits of active and passive investing. Fans of active investing say fund managers who analyse companies they invest in can make money by picking winners and selling before they fall.
One drawback is that the analysis involved in active investing costs money. Research by US academics Eugene Fama and Kenneth French showed that once costs were taken into account, investors in active funds saw actual returns below those of an equivalent portfolio of passive funds. The paper is not alone – similar research over the years from different parts of the world reached similar conclusions. However a study out of Yale University in the US found funds that employed the most active investment strategies outperformed the benchmarks, even after fees.
Supporters of passive funds often question the ability of any particular active manager to consistently outperform their benchmark. Many also argue passive funds benefit from lower management costs (which may include an annual management charge and transaction fees for the buying and selling of shares and bonds). Because passive investing typically involves fewer trading decisions, management and other fees to be lower.
Over long periods, even small differences in fees add up. The total expense ratio (TER) measures the total charges for fund investors. An analysis published by website Trustnet calculated the TER of passive funds at 0.79% annually compared with an average of 1.53% for active funds benchmarking the UK FTSE All Share. A particular form of passive investing that has developed since about 2000 is Exchange Traded Funds (ETFs). These ETFs trade in a manner similar to individual shares, meaning they can be bought and sold rapidly.
Your bench(mark) or mine?
No matter whether investments are actively or passively managed, the returns will be influenced according to which index has been selected as a benchmark. Until recently, UK tracker funds tended to follow the FTSE 100 or All Share indices. But more funds are now available so it is possible to track more exotic indices passively. That choice is made by the individual investor.
The role of asset allocation
Remember the decision around active or passive investing is not the only one investors need to make. Choices about diversification and how much risk to take on are also important. The eZonomics video The lifecycle approach to investing suggests a way to reduce risk exposure as an investment gets closer to maturity.