Page 12 - DIY Investor Magazine - May 2019

THE GREAT DEBATE: ACTIVE & PASSIVE FUNDS
Life is full of debate: milk before tea or tea before milk, cats versus dogs, the best James Bond? The investment industry is no different and is currently divided on the active versus passive debate, with strong feelings on either side – writes Tom Poulter, Head of Quantitative Research, Square Mile.
At Square Mile we believe the debate needs to be re-framed a little. A portfolio should consist of a combination of the best funds to meet the investor’s objectives. That may be active, passive or a blend of both, at a cost that represents value for money.
With that in mind, when is each type of approach appropriate? The decision will depend on several factors including the asset class and region, the cost sensitivity of the investor and their time horizon.
LIKE WITH LIKE
Firstly, before we critique active or passive funds, we need to make sure we are comparing both types of funds fairly. Currently, most investors compare a fund’s performance against its benchmark, which is usually an index or a sector. However, it is impossible for an investor to obtain the exact exposure and performance profile of a sector or an index, due to factors such as trading and management fees.
Square Mile believes that it is more appropriate to compare an active fund to an equivalent passive fund, for example a UK Equity fund benchmarked against the FTSE All Share Index should be compared against an equivalent passive fund that tracks the FTSE All Share Index. This gives a comparison that is closer to the investor’s real experience.
ACTIVE FUNDS
Active funds have a number of appealing characteristics. Key for many investors is their ability to offer the potential to provide superior returns over the index.
Although this is not guaranteed, and plenty don’t succeed, passive funds don’t have this ability at all.
Active funds can also offer other characteristics, such as generating an income, preserving capital and protecting against inflation. The manager of an active fund has the
‘ACTIVE FUNDS CAN ALSO OFFER OTHER CHARACTERISTICS, SUCH AS GENERATING AN INCOME, PRESERVING CAPITAL AND PROTECTING AGAINST INFLATION’
ability to avoid significant drawdowns during periods of market stress. They can anticipate and respond to market turmoil, rather than simply following the index. This allows active funds to provide investors with a “smoother” journey.
Managers also have greater flexibility in where they can invest, so they do not blindly invest in specific regions/ industries and stocks. They can look forward, striving to find tomorrow’s winning companies, rather than relying on yesterday’s winners.
At the same time, investors have greater choice, allowing them to invest in a fund that best suits their needs.
PASSIVE FUNDS
All the same, there are a number of reasons why an investor would choose a passive fund. Notably, they are generally cheaper than their equivalent active fund. However, there are exceptions.
In the UK All Companies sector the Ongoing Charges Figure, OCFs (previously Total Expense Ratio – TER), range from 0.06% to 1.51% for passive funds, while the range for active funds in the same sector is 0.22% to 2.91%*.
(*Source: FE Analytics as at 30th May 2018)
Passive funds often have greater transparency, allowing investors to have greater insight into their portfolio’s risk characteristics, although this may change as active managers are being pushed (quite rightly) to improve disclosure.
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