Active or Passive Investing?

A mighty question. Some go for the passive index funds. Others leave it to professional mutual funds. Some people are avid fans of dividend growth investing – hugely popular among those creating a portfolio for financial independence. Some people firmly believe they can beat the market with small cap and risky stocks. Sometimes savvy investors do.  But, deep down, they know this performance isn’t sustainable year on year. Is it? Surely emotions get in the way leading to under-performance, and then more emotion. It’s a merry-go-round! So what should you do with your money?

What is Active Management?

These are funds run by professional managers and research teams who decide where your money is going to be invested on your behalf. Depending on the type of fund you choose, the aim is to generate a return that is greater then the market (you could also choose target return funds which aim to generate a constant return without loosing capital). It also means there is someone always managing you money, so if there was a sector that was suffering the manager could move your money elsewhere. Likewise, if a sector was performing well a manager could invest to expose you to the growth.

Why Is Passive Investing Different?

Index funds or ETF's track a particular market. These funds are mainly run by an algorithm which does all the trading to make sure all the assets of the chosen market are brought and in the correct proportions. As there is little human involvement in research and managing, the fees are much lower. The Vanguard S&P500 ETF has an expense ratio of 0.07%, so for every £10,000 invested the fee is only £7. These low fees mean hundreds of billions are being moved from active funds to passive funds every year.

Why Has So Much Money Shifted To Passive Investing?

Theoretically, professional fund managers devote their lives to investing and should be able to recognise trends in the markets. Depending where you look, some research has shown that actively managed funds did outperform passive indices (only by less than 0.5%) but this is before any associated fees. According to the Financial Times, over 10 years 83% of active funds fail to match their chosen benchmarks. 40% perform so badly they don't even last those 10 years. Fees then can be expected from active managers include:

• Expense Ratio – often around 0.75% to 1%, this percentage covers costs associated with the running of a mutual fund. Costs include employees, computers, office rent/supplies and so forth.

• Trading Costs – As a manager makes trades on your behalf, costs are incurred and passed onto you.

• Broker Commissions – if you invest through a broker they charge a fee for their services too. And don’t forget the broker may select funds that pay them the most to promote, rather the those that outperform. This fee can range from 0.25% to 0.75% in a tax efficient ISA.

And you will still have to pay the fees even if the fund produces a negative return. So its not hard to see why investors are withdrawing their funds.

Having said that, there are funds with skilled managers that have build up a reputation for consistent returns, and people are happy to pay their fee.

Where Do I Invest? 

I place myself smack bang in the middle – a hybrid position. Index investing allows me to gain the diversity across many different companies, especially those that are foreign. As a UK investor, I am hit with all sorts fees if I wish to purchase foreign stock and as any educated investor knows, fees eat away at returns. I like to keep around 25% of my portfolio in an S&P500 index – I’ve chosen Vanguard with the 0.07% expense.

I also pick a few companies myself. This can be due to their products that I use, a slightly higher yield, because they appear undervalued or they have favourable fundamentals. Examples of companies include Unilever, Diageo and Reckitt Benckiser. Diageo has Smirnoff, Captain Morgan, Gordon's Gin and Guinness brands under its belt. People are loyal to brands allowing these companies to generate high ROE and profit margins.

Related: Company Performance Tracker

In order to lower risk and still generate a satisfactory return, have a look at The Efficient Frontier. It shows why you should never be 100% allocated to bonds.

Whatever route you decide to go, make sure you do your own and thorough due diligence.

~ DM