Education – Active and passive investing

There has been an ongoing debate for many years on the relative merits of active versus passive investment approaches. For a long time, active has been favoured but passive is growing in popularity. According to Morningstar, and reported in the Financial Times, assets managed in passive funds have grown 230% since 2007, reaching a total of $6 trillion. This growth is four times faster than active products over the same period.

The big question used to be: which is better? But should you favour one over the other, or use both? In the current environment of relatively low returns, investors should be looking at every possible way of generating the best performance (net of charges) from their portfolios.

First, some definitions:

  • Active fund managers are so called because they are able to take active decisions to make their portfolio look different from an index or benchmark – to choose the equities, bonds or other assets they want to invest in. They aim to meet a specific, defined investment objective.
  • Passive investments, on the other hand, will seek to closely replicate the performance of a market index. True passive managers don’t make decisions about what to invest in; they simply track what is in a particular market index.

The views expressed in this section are those of the fund managers and not those of TD Direct Investing.

Exchange Traded Products (ETPs) including ETFs, ETCs and ETNs track a wide variety of underlying investments, some of which may be complex in nature and involve leverage, shorting or a high degree of volatility. It is therefore important that you read the Prospectus or Fact Sheet (available on the issuers’ websites) prior to investing and ensure that you understand how it is structured and the associated risks.

We think there is room for both, and the best approach for investors is actually to take the best parts of each and include them in their portfolio – not active versus passive but active and passive.

Active management will always have a place

There is still definitely a place for active fund managers who are able to demonstrate consistent skill over the long term. Even major player in the passive world BlackRock, which has the largest Exchange Traded Fund (ETF) business in the world, recently hired a new head of global active equity, and Robert Kapito, president at BlackRock, believes active funds will offer investors a chance of outperformance. He says: “In a lower return environment, incremental gains from active management have a stronger impact on performance.”

The challenge for investors is how to select the right active managers to fit a certain investment strategy. Our Recommended Funds list is one way of identifying strong active managers with consistent track records across a broad range of asset classes.

There are challenges, especially in the US

Here in the UK we often take our lead from what is happening in the US, and the landscape there is changing dramatically for active managers. While a few active US equity fund managers have been able to outperform the US stock market on a consistent basis, the majority don’t, which is why passive is becoming more popular.

This is due in part to the fact the US market is the most efficient in the world. The vast majority of companies, aside from a number of micro caps, are well researched. This makes it extremely difficult to discover and act on information about a company which is not already in the public domain.

While in the UK a higher number of active fund managers beat their benchmarks, relatively few do it on a consistent basis. And the question of charges is becoming ever more important, particularly during a period of low returns.

Active managers are responding

So how are active managers going to respond? They’re looking for ways to become more competitive on fees, so they can compete with the lower cost, passive, alternatives and outperform their benchmarks. Another trend is the rise of active managers becoming more opportunistic and less rigid in terms of following an investment style.

Passive is growing fast

Meanwhile, investors are increasingly turning to passive solutions. Ben Johnson, who researches passive investments for Morningstar, notes an increase in ETF usage in the US market, with passive funds due to take more than 50% market share within the next year or two. In the UK, there has been a noticeable uptick in the adoption of tracker funds and ETFs, with companies such as Vanguard, BlackRock and ETF Securities taking significant market share.

The growth in global ETP assets

Investment skill: asset allocation vs stock selection

Some investors are already adopting a passive approach to access certain markets. While these investors are no longer making stock selection decisions they are required to make asset allocation decisions. For example in 2015 the FTSE All Share index returned 1% while the FTSE 250 achieved 11%. Are you experienced and qualified enough to make the decision on which to invest in? How do you go about monitoring and rebalancing your portfolio?

All this means you are still effectively taking an active approach to manage your passive portfolio. An approach such as that taken by Vanguard, Blackrock and several others, where the asset allocation is done for you, could be appropriate for some investors.

Performance growth of £1000 over five years for Vanguard LifeStrategy Growth (60% equity)

Bill McNabb, chief executive officer of Vanguard, one of the major global players in the passive investment space, agrees. He believes investors should “buy the market” via passive products such as exchange traded funds (ETFs), then use active funds as satellite positions around them. Vanguard offers a range of passive LifeStrategy funds which are intended to be used as low cost core building blocks for a portfolio (the ongoing charge on the Vanguard LifeStrategy Growth Fund, for example, is 0.24%). For us this approach makes a lot of sense. The central part of your portfolio can be formed using a low cost passive strategy, and depending on your risk profile you can add some active fund exposure.

Source: Morningstar, as at 22 June 2016

Figures from BlackRock show $10.7 billion of assets flowed into exchange trade products (ETPs) globally in May this year. Year-to-date (to the end of May) that figure is $93.4 billion (note that the assets chart above shows total assets minus outflows and performance growth). These are significant numbers and highlight just how popular passive strategies are becoming. These include smart and strategic beta, which refer to strategies which use alternative ways of building indices to the traditional market capitalisation weighted approach.

"A more diversified set of investors have a better understanding and a more positive stance towards ETFs than in the past,” says Matthew Tucker, head of iShares US fixed income strategy at BlackRock. “This is happening across asset classes and across geographies. However, the biggest challenge of the growth of ETFs is how to increase education and awareness."

Active fund manager investing

The pros... ...and the cons
  • Your fund manager may be able to outperform the market based on his or her skill.
  • There are a variety of investment styles and strategies to choose from; it’s up to you to find managers and funds that fit your strategy.
  • Gives you the flexibility to pursue specific investment opportunities within your portfolio.
  • Performance depends on the skill of the manager; whilst this is also a good thing, your investment is under the direction of someone else.
  • Costs of active funds are typically higher than passive because you are paying for the time and effort required of the fund manager.
  • It takes time and effort on your part too, because it is important to research the funds you are interested in and ensure they are meeting your objectives.

Passive tracker investing

The pros... ...and the cons
  • You know what you’re getting and you can possibly gain access to the performance of hundreds of different stocks (depending on which index you track) as opposed to a selected few.
  • Little risk of underperforming the market because – you’re buying a bundle of investments so there is a sense of safety in numbers when tracking an index.
  • Cheap and easy access to the market because you’re not paying someone to manage it for you.
  • Lack of choice – while you potentially have exposure to lots of stocks in an index, you are limited to that index.
  • Little prospect of outperforming the market because whatever the market does you’re likely to do the same.
  • Depending on what you choose you might be limited in your choice. So if you choose to track the FTSE you have a diverse selection of stocks but only in the UK. Equally, tracking a commodities index gives you global coverage but only in one sector.

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