Active v Passive Investing – Neither is Better And Here’s Why

“Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index. In passive management (or passive investing), investors expect a return that closely replicates the investment weighting and returns of a benchmark index and will often invest in an index fund.”

The debate about whether active or passive investing is the best way to go is one of the most misguided within the investment world. This is because the debate itself is based on a completely false premise.

The fanatics on either side need to wise up. The fact there is even a debate at all is a bit like the magician tricking you by deceiving you into seeing what he wants you to see for the purposes of his trick.

First off, just to position this; the whole passive argument is completely undermined straight away because the word ‘passive’ is a misnomer.

Anyone proposing a passive approach, or any investor following a passive approach, is not acting ‘passively’. The decisions being taken – at outset and all the way through the period of investment – are, in so many ways ‘active’.

You have to actively decide which assets to use, which markets to track. If for example you decide to put some of your invested monies into the UK Equity market, you still need to decide how much (as a percentage of your overall portfolio), whether to use an All Share tracker, or a FTSE 100 tracker or a FTSE 250 tracker, whether to use an OEIC or ETF, and then as you proceed whether to keep the same percentage invested, and decide when to switch and rebalance, if at all.

If you decide to invest and stick with your original decision, through good times and bad, through ups and downs, then that is as much as a decision as making regular changes.

All in all, passive investing still requires lots of active decisions. What passive investing really means is index tracking investing. Using market tracking funds instead of active funds. So the debate terminology needs to be “active or tracking?”

This leads to our second point; one which can sometimes take a little getting your head around.

The average return of all active funds in a market is exactly the same as the average return of all tracking funds in that market, all other things being equal (which they are not, more of this in a moment).

So the two alternative methods revert back to the same average return?

Take the market in UK shares; the active funds, totalled up, make up the market, more or less. Therefore the market index, say the All Share index, is a factor of this total. The performance is therefore averaged to produce the index performance. This average is the average of the active investments in that sector. Trackers follow this average.

The above is ever so slightly over-simplified, but academic research shows this to be the broad case in virtually all markets, all of the time.

On the average, tracker funds do not-out perform active funds, but this is just as true the other way round. Neither one is better than the other. However, that assumes all other things are equal and they are not.

Tracker funds tend to be cheaper than active funds. This cost differential does produce a swing in favour of trackers. Let’s assume the gross return (before costs are factored in) from the UK share market will be 5% per year in the next period.

A typical tracker fund might charge 0.5% per year, whereas a typical active fund 1.5% per year. Let us assume these are the average costs, across the sector. Now the comparison swings, because the average tracker returns 4.5% net per year, the average active fund 3.5% per year.

That means tracking wins. But, does it? If you work on the basis that you will only ever get an average return from an active fund, then, yes, you should use trackers. Full stop.

However, if you can find active funds which are better than the average (and there are some which have track records over long periods which suggest this may be feasible) you can swing the balance back in the other direction.

The debate is really this: neither way is a better way of investing; what needs to be determined is can you find funds which are consistently better than ‘average’ – better, by enough, to wipe out and pay off the cost difference?

We think the answer is ‘yes’ this can be done – but care needs to be taken, which is why we prefer to look at investors own positions, their views and create a fund portfolio accordingly, sometimes around trackers, sometimes around active funds, sometimes both.

There is one more thing, which ultimately, trumps everything else above. Asset allocation not fund selection is the most relevant factor in determining returns. Your decision how to allocate your portfolio into different asset areas will be something like 70% relevant to your outcome. So whatever funds you select, whether active or trackers, will be much less significant than the asset allocation you pursue.

The debate about active or passive is superfluous or a distraction; don’t be deceived by where “the magician wants you to look” and be careful of getting sucked into one camp or the other, neither is right, neither is wrong.

We are here to guide you. If you would like to speak to us about these critical investment decisions please give us a call on 02920 450 143 or email info@penguinwealth.com.