Investment funds – 12 pros and cons of active and passive funds

03/11/2020

By David Snelling

We’re commonly asked: ‘are actively managed or passive investments better?’ Read more to find out the pros and cons.

A common question we get asked about investing is whether actively managed or passive investments are better.

The answer? It depends.

And, because it depends, we thought it would be useful to outline some advantages and disadvantages of active and passive investments.

Active and passive strategies can invest in a wide variety of investments and will each have a particular investment mandate which they must follow.

Active funds

An ‘active’ fund is a pool of investments which is being actively managed by a fund management team. The fund manager will buy and sell the underlying investments as and when they wish, based on their research and opinions.

Simply, the job of an active fund manager is to outperform the benchmark/market for their investment mandate. For example, a manager with a UK Equity mandate will likely be tasked to beat the FTSE All-Share Index performance.

Pros

  • Potential to obtain better than average market performance*
    • A good fund manager may be able to achieve better than the market returns over a medium to long period of time. This could be due to the fund management team’s skill and experience in their investment sector.
    • An active fund manager can make changes to the fund’s investments to manage market events, such as a market crash.
  • Good for niche or complex markets and sectors
    • If you wish to invest into complex investments or sectors (for example, Latin America), accessing an active fund manager may be prudent. This is particularly useful in under-researched markets where on the ground presence and understanding of the market will give clear advantages over a passive counterpart.
  • Research into the underlying investments
    • An active fund will have a team of people working to obtain research and data regarding the fund’s holdings. They will also be analysing new companies to invest in as well as monitoring existing investments to ensure they remain suitable. For example, they may speak with the directors of a company before investing, which could give them more insight than a typical investor.

Cons

  • *Market underperformance
    • Many managers do not add any value to a portfolio versus a passive fund – and may even provide worse investment returns.
    • Past performance of successful fund managers should not solely be used to invest in a fund. For example, see the once successful Neil Woodford who launched his own fund to much acclaim, but which has lost money for many investors!
  • Fund management fees
    • Active funds typically have higher ongoing fund management fees. Therefore, to be successful and worthwhile investments, active funds need to outperform the market after taking into account their fees.
  • Some fund managers are closet trackers
    • Simply, the fund manager just chooses a very similar asset allocation to the market their performance is judged against. This means they will get close to average returns but will charge higher fees than a passive fund. Read more

Passive funds

These come in the form of index tracking funds and Exchange Traded Funds (ETFs). They are referred to as ‘trackers’ because they track a set benchmark or index. For example, a global equity passive fund may track the MSCI World index.

The passive investment will only aim to replicate the market (or index) return of the investment mandate: in the example above, global equities.

Pros

  • Low cost
    • Typically, passive funds are lower cost than active funds.
  • Market returns
    • As a passive fund will invest (in proportion) in whichever market or index it is tracking, the fund will obtain roughly the market return minus fees.
  • Well diversified
    • As the fund typically tracks a specific market or sector index, if the index has 500 companies (e.g. the S&P 500) then the underlying holdings in an S&P 500 passive investment will be 500 companies. Conversely, an active US equity fund will not hold all 500 companies.
    • However, if a one or a few companies are dominant in their market, then the passive fund may not be as well diversified as you’d expect. It is well known that the S&P 500 index has a large weighting towards just a few large and well-known technology firms.

Cons

  • You will not get above market returns
    • By investing in a passive fund, you are effectively investing in the market or index. Therefore, you will not get above (or below) market/index returns.
  • A passive fund buys the market and therefore will buy ‘blind’ without considering the worthiness of the underlying investments
    • This may be an issue, particularly, if a company which makes up a high percentage of the fund turns out to be a bad investment. An active manager may have realised the company was a bad investment and decided not to invest.
  • No ability to react to market changes
    • For example, if a serious event happens which is affecting the market, the passive fund will just continue to hold the market/index. There is no ability to dis-invest to reduce downside risk or invest more to take advantage of temporary falls in an investment.

In summary, to increase investment returns (after charges) there is no easy answer as to which is better, as overall, there are pros and cons to both active and passive funds.

Typically, many diverse portfolios will contain a mixture of active and passive funds, depending on the investment market or sector as well as any preferences of the investor.

At Charlton House, we can help you select a portfolio which meets your objectives. For more information please contact us by email or, if you prefer to speak to us, you can reach us in the UK on +44 (0) 208 0044900 or in Hong Kong on +852 39039004.

 

Note – any views and opinions expressed in this article are those of the author only and may not be correct. This article does not constitute financial advice and you should always consult a qualified financial professional before undertaking any financial changes. The information in this article is correct as at 1st November 2020. Investments contain risk and you may lose money.

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