Active or Passive Investing

Whilst asset allocation is the main contributor to the performance of a portfolio, our investment philosophy also adds value to the investment process. Our investment recommendations to our clients will always reflect our investment philosophy and so it is important that this be fully explained.

There are two main schools of thought; one that outperformance can only come from Active Management and one that believes that driving cost out of the portfolio will generate better returns over the medium to long term.

Passive investing is a style of management where a fund’s performance aims to mirror a market index. Followers of passive management believe in the “efficient market hypothesis” which states that at all times markets incorporate and reflect all information, rendering individual stock picking futile.

Passive management is the opposite of active management, in which a fund manager attempts to beat the market with various investing strategies. Active stock pickers believe that the market is not completely efficient and that it is possible to add value for their clients by exploiting pricing anomalies.

The objective with active management is to produce better returns than those of passively managed index funds. For example, an active fund manager focusing on large capitalisation UK companies would look to beat the performance of the FTSE 100 index whilst a passive index tracker would look to replicate the performance of the index.

Are markets efficient?

Although it is a cornerstone of modern financial theory, the efficient market hypothesis (EMH) is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis.

While academics point to a large body of evidence in support of EMH, there are also plenty of notable dissenters. For example, investors such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. Detractors of the EMH also point to events such as the 1987 stock market crash, when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values.

Advantages of passive investing:

• Passive funds tend to have lower charges than active portfolios. Since they simply replicate the index, there is little intellectual input and thus management fees are relatively low.
• Risk of significant underperformance versus their chosen index should be limited. Thus, passive funds would appear ideally suited to cautious investors, as long as those investors are aware that markets can fall as well as rise.
• Trackers are also ideal for investors that may not be able to carry out due diligence to ascertain which active managers best suit their needs.
• Passive government bond portfolios can be an efficient way for pension funds to match assets and liabilities.

Disadvantages of passive investing:

• It can be difficult to discriminate between trackers. Since they are required to mimic their benchmark indices, there is no simple way to tell whether one index fund is better than another. One of the very few ways to compare index funds is to use the tracking error, which is a measure of the degree to which a fund’s performance deviates from that of its target index. Surprisingly, tracking errors can vary widely between different passive funds. However, tracking errors are backwards looking and complex and can be calculated in different ways, making comparisons difficult.
• Passive funds tend to buy at the top of the market. All indices are rebased regularly, with stocks moving up to take greater weightings, entering the index for the first time or dropping out completely. As a stock becomes a greater proportion of an index, a tracker will take a greater stake. However, this tends to happen after a company has performed well, which means that the tracking fund is buying as the share price increases, and such hikes can be exacerbated by market trends or investing fads.
• The dotcom boom of 1999 provides a perfect example of the dangers of passive funds. The fever for technology stocks led to an increased representation of technology stocks in many indices. However, indices rebalanced towards tech stocks just as the market hit its peak in March 2000. Consequently, while passive investors would not have gained fully as these shares shot up in value (as some were not significant parts of the index), they were fully exposed to the technology sector just when the bubble burst. Indeed, this exemplifies one of the key criticisms of index funds: they replicate past performance rather than looking at the future.

Advantages of active investing:

• These types of funds offer different investment aims rather than just tracking the market as a whole. Therefore by managing investments actively, investors can choose to manage volatility by investing in funds that are deliberately targeting higher or lower levels of risk.
• Investors may disagree with the efficient market hypothesis, and therefore believe that there is the ability to generate additional performance by finding undervalued companies in the market place.
• Investments that are not highly correlated to the market are useful as a portfolio diversifier and may reduce overall portfolio volatility.
• Some investors may wish to follow a strategy that avoids or under-weights certain industries compared to the market as a whole and may find an actively-managed fund more in line with their particular investment goals. For instance, an employee who receives company stock or stock options as a benefit might prefer not to have additional funds invested in the same industry.

Disadvantages of active investing:

• The most obvious disadvantage of active management is that the fund manager may make bad investment choices or follow an unsound theory in managing the portfolio.
• The fees associated with active management are also higher than those associated with passive management, even if frequent trading is not present.
• Large managed funds can begin to take on index-like characteristics because they must invest in an increasingly diverse set of investments instead of those limited to the fund manager’s best ideas.

Based on the above and our other research we believe that any decision to invest into passive or active funds (or a combination of both) should be made after full consideration of your financial goals and resources, risk tolerance and time horizon to invest.