Active or Passive Investing

October 2017
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When deciding how to invest there is a choice between active and passive investment funds. What is the difference and when should investors choose active or passive investments? 

Active investment managers employ researchers who conduct analysis of economies, business sectors and individual businesses, before deciding how to invest the money entrusted to them. Some active fund managers may be represented on the board of the companies they invest in. They can vote at shareholder meetings and may seek to influence the decision making of the business. 

Passive investment managers do not believe that there is sufficient value in such research and activity to justify the cost of it and instead they invest in companies which are representative of the components of a given index or which meet an agreed criteria. Companies are selected without reference to any specific risks or opportunities with which they may be presented.

Passive fund managers make rules governing the selection of companies included in them which are established at the outset. They are often then governed on an ongoing basis by an algorithm which will determine when companies are bought and sold and the proportions in which investments are split between them. The criteria used are many and can be on the basis of size of the companies, the income yield produced or aligned to a given stock market index such as the FTSE 100 or a business sector such as resources, technology or pharmaceuticals. 

Passive funds offer the investor the benefit of low charges for management of the investment. Fewer people and resources need to be employed and these cost savings are passed on to the investor. A typical ongoing charges figure for a passive fund would be 0.15% of the fund value per annum. 

Active fund managers will typically charge between 0.45% to 1.5% per year, depending on the fund and whether it is bought via the institutional or wholesale market, where lower charges apply or alternatively direct from the fund manager in the retail investment market. 

Passive funds offer the investor the clear advantage of lower charges. Advocates of passive investing claim that most active managers do not perform better than the index consistently and so cannot justify the extra cost of investing. 

While it is true that in any given period, half the active fund managers will perform below the average return of the index, half will also outperform. The skill of the investment adviser is in selecting those funds which consistently perform and which take the right amount of investment risk to meet given financial objectives, so that the volatility in value of the investment is acceptable to the investor.

Critics of passive investing argue that by buying and selling funds on fixed criteria such as size of the company, rather than looking at company specifics, portfolio returns will be hampered by the inclusion of companies which may already be past their prime. This argument has particular relevance in a period of great technological change. 

For many investors investing in both types of fund can be appropriate. Where time horizons for investment are long, where the purpose of the investment is for discretionary spending, rather than specific needs, the benefit of the low charges of passive funds can outweigh their disadvantages. 

Where investments are required for more short term and specific needs, such as regular retirement income or funding education costs, active funds offer some advantages which may outweigh their higher charges, if these also offer some risk controls and consistent performance. Most investors may benefit from both types of investment at different times.

Kay Ingram
Director of Public Policy, LEBC

Please remember, no news or research item is a recommendation or advice to buy. LEBC Group Ltd is not responsible for accuracy and may not share the author’s views. If you are unsure of the suitability of any investment or product for your circumstances please contact an adviser. Investments can fall as well as rise in value so you could get back less than you invest. 

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