04 Jul 2011 | Capital Hill

Capital Hill on... passive versus active investment 

IT’S an age-old investment debate, but one that has been stoked recently by the growing dominance of commodity stocks in Britain’s FTSE 100 index: which is best, passive or active investment?  

Proponents of passive funds cite research that shows few active managers beat the market: investors pay handsomely for underperformance. Passive investment, they say, is a lower-cost, lower-risk way to tap into markets.  

However, those in the active camp point to the fact that passive investors, by their nature, always underperform the market they’re tracking after fees come off. They miss out on the substantially better returns that good active managers can deliver, even after their higher charges.  

Here, Capital Hill looks at both sides of the debate...
 

What’s a tracker fund?

Passive funds, or ‘trackers’, aim to mirror the performance of a given stock market index or sector. They’re priced on a daily basis and have no initial charges, with a typical total expense ratio of between 0.3% and 1%.  

Traditional trackers cover equity markets, but in recent times the variety of funds has grown enormously. Exchange traded funds (ETFs) and exchange traded commodities (ETCs), although traded like shares, behave like trackers, and enable investors to track anything from the price of oil, gold or orange juice to cotton, lean hogs, water and timber.  

The argument for passive funds is based on cost and performance: these funds are often deemed by investors and advisers alike to be cheaper and less risky.
 

What are the risks?

You might think your tracker fund is incredibly low-risk, but is it? Risk should not be confused with adherence to an index. Index tracking is not a safe option, particularly as the FTSE 100 becomes increasingly concentrated.  

Most investors looking for a cheap way to track the UK market will buy a FTSE 100 tracker or ETF, but what exactly are they buying? The answer is 42% exposure to the two largest sectors (financials and oil and gas). Investors also receive 37% exposure to commodities through the energy and mining sectors – a figure that rose last month with the addition of Glencore to the top flight.  

The Swiss commodities giant raised $10 billion when it floated, adding to the number of miners in the FTSE 100’s top ten. This means many trackers will be buffeted by commodity prices – not ideal for what some advisers recommend as a core holding.  

Ben Yearsley, an investment manager at Hargreaves Lansdown, the adviser, said: “Sector-specific risk can be high for passive investors. It’s almost self-fulfilling: a sector becomes popular, trackers have to buy more, making it even more expensive. This is the biggest danger with trackers: there’s no leeway to avoid expensive and over-bought sectors.”  

There are dangers, too, lurking in ETFs, with the Financial Stability Board warning over liquidity concerns and counter-party risk on swaps. To find out more, see Capital Hill’s analysis here
 

What’s an active fund?  

Active fund managers aim to beat average stock market returns by identifying shares that will outperform others. By being more focused, managers can avoid large parts of the market that passive investors blindly hold. Technology stocks were battered with the dotcom crash in 2000, while banking stocks plummeted amid the recent financial crisis. Financial stocks accounted for 27.6% of the FSTE 100 prior to the subprime mortgage crisis. The index fell 42% in nine months.  

So, active management involves closer monitoring and more detailed research, but it can come at a cost. These funds typically charge 1.5% a year – which is used to fund research, wages and other costs associated with physically managing the money, plus commission paid to independent financial advisers and fund platforms through which the funds are sold. Other costs, such as share registration fees, auditing costs, custodian and legal fees, are added on top of  this charge

While actively managed funds are generally more expensive, they are not  exclusively so.  For example, the Scottish Mortgage Investment Trust, is an actively managed global trust with a current annual charge of around only 0.5%.   

Active management can pay handsomely. Consider this example from Chelsea Financial Services, the independent discount broker: during the decade of the noughties, the FTSE 100 lost 22% in capital terms and gave a total return (with dividends) of 8%. The top-performing UK fund, Fidelity Special Situations, returned a staggering 180%.
 

What are the risks?  

While some funds hugely outperform, others spectacularly fail. The latest Spot the Dog report from broker Bestinvest shows that there’s £10.35 billion sitting in underperforming funds, earning managers and advisers over £150 million a year in fees.  

The US, the world’s largest stock market, has been the graveyard for poorly-performing funds, with 34 out of 48 funds underperforming the S&P 500 over a decade. That has cost investors £102.9 million in charges alone, before performance losses are factored in.  

Bear in mind, too, that some actively-managed funds are nothing other than closet trackers – meaning investors are paying a premium for funds that stand little chance of beating the market.  

Barry O'Neill, investment director at Carbon Financial Partners, the Edinburgh-based independent financial adviser which advocates passive investment, said: “The myth that active managers avoid concentration risk can be exploded just by taking a look at the top ten holdings of actively-managed funds, whereby you’ll see a remarkable resemblance to the index against which the performance of their managers is judged. Actively-managed funds that fit this bill serve to line no-one’s pockets but the fund manager and their employer.”  

However, active investors often take steps to ensure they’re not ‘closet indexing’. Writing in Working Capital, Baillie Gifford’s investment journal, Colin Renton said: “With thorough analysis, a long-term investment horizon and by identifying irregularities in the market, it is possible to achieve higher returns with active management.  

We back our judgement and run concentrated portfolios. We are prepared to deviate significantly from the benchmark and use measures such as common money – an overlap between our funds and the index – to confirm we are not closet indexing.”
 

Should you mix and match?  

For many, the debate is far from black and white. AWD Chase de Vere, the independent financial adviser, sometimes use passive investments to get exposure to large cap UK equities, but will always hold other investments alongside this.  

“The bottom line is that if you invest in equities you’ll be taking risks and these can’t be avoided simply by adopting either a passive or active approach” said head of communications Patrick Connolly.  

“The only way to diversify risks is to invest in a wide range of investment markets and asset classes, so that you’re not overexposed in any particular area and your investments aren’t all going up or down together.”  

Adrian Lowcock, a senior adviser at Bestinvest, agrees. “As a rule, we try to identify an active manager in a particular sector that justifies their fees. Where one can’t be identified, we tend to opt for the passive alternative,” he told Capital Hill.  

“However, there are times when a combination will deliver better returns for investors; both have their pros and cons.”

The views that are expressed in this article should not be taken as fact and no reliance should be placed upon these when making investment decisions. They should not be considered as advice or a recommendation to buy, sell or hold a particular investment.

This article contains information and opinion on investments that does not constitute independent investment research and is, therefore, not subject to the protections afforded to independent research.

Please remember that changing stock market conditions and currency exchange rates will affect the value of investments and any income from them. Investors may not get back the amount originally invested. Past performance is not a guide to future performance.

Author: Jennifer Hill
Jennifer is an award-winning British financial journalist. She recently left The Sunday Times, where she was deputy Money editor, to set up her own company, mediahill Ltd. She is a previous personal finance correspondent of Reuters, the global news service, and personal finance editor of The Scotsman newspaper.

She has won or been shortlisted for six Headlinemoney awards, the ‘Oscars’ of personal finance journalism in the UK. She has also scooped or been nominated for accolades from the Association of Investment Companies, Ignis Asset Management, the Association of British Insurers and the British Insurance Brokers’ Association.