Active versus passive

Jason Baran – Insight Analyst (Investments)

In my talks with retail investors on the subject of active versus passive managed funds, it’s often the case that a clear opinion has been formed in the direction of one view without a full grasp of the facts.

In reality, both active and passive funds have a role to play in an investor’s portfolio.

History and growing popularity

Passive funds have been around since the 1970s, but only recently have they become more accepted in retail investor portfolios.

Three main factors have been driving this:

1. An awareness that active managers don’t necessarily outperform their benchmarks
2. Increased transparency on fees and their potential impact on returns
3. Post-RDR, advisers are now free to recommend passive funds which traditionally never paid commissions

At Defaqto, we see the rising popularity of passive funds as a good thing. Prior to their introduction, the only option for investors with an underperforming active fund manager was to move to another active fund manager. This involved transaction costs and again rolling the dice on whether the active fund manager would outperform.

With passive funds, investors now have another strategy available to compete with active management, and passive funds are helping lower costs for investors across the fund management industry as a whole.

Misconceptions

This section demystifies a couple of the misconceptions in the active versus passive debate:

Fund performance versus the benchmark 

Several studies have been done on active managers, and it's been reported that roughly 75% of them will underperform their benchmark over three years or more.

However, this doesn’t mean that investing in a passive fund automatically makes more sense. While passive funds aim to track a benchmark, they can never do this exactly. For developed markets, such as US and UK equities, passive funds are able to track very closely as the markets they follow are large, liquid and have relatively low transaction costs. These markets also tend to be well regulated and with a high proportion of invested active managers. For example, in the UK 90% of funds are active and 10% passive. This leads to them being more ‘efficient’ and hence lowers active return versus passive.

However, if you look at some fixed income, emerging and alternative markets, tracking error can increase dramatically as transaction costs rise and liquidity decreases. This particularly affects passive funds that don’t aim to add value via individual stock selection and are affected by the increased costs of replicating an illiquid index. Indeed, recent studies have shown that passive funds are more likely to underperform active managers in emerging markets.

Passive funds outperform because they are cheaper

Following the RDR in 2008 and UCITs European regulation introduced in 2012 (a set of European directives aimed at encouraging a single market in collective investment schemes), funds wishing to sell to retail clients in Europe now need to post an ‘Ongoing Charge Fee’ that better explains the true cost of investing to a client than the previous requirement of TER (total expense ratio) and AMC (annual management charge).

This has enabled better comparison with passive funds, which typically charge 0.5% to 2% less than their active equivalent each year.

While lower fees are definitely a driver of better returns, investors should also be aware of the following when choosing their fund:

• ‘Loading fees’ – the upfront charge a fund makes for a new investment. Loading fees were traditionally charged by active managers, but some passive funds also charge a nominal loading fee, for example one provider charges an ‘anti-dilution’ levy for some of their funds; this fee can also differ depending on the fund platform used to make the investment
• Bid/offer spread – the cost of buying and selling the fund. The bid/offer spread will be paid by the investor when they sell their investment

Again, the consequences of this are that passive funds don’t necessarily deliver a benchmark return.

It's not that one is better than the other

Passive funds have gained significant fund inflows over the past five years due to regulatory changes and increased cost transparency. However, beyond the headline of ‘lower fees’, investors still need to pay attention to the details, in particular tracking errors and big-ask spreads.

With active versus passive an investor faces a choice of:

• Active: Paying a relatively expensive fee for a small chance of outperforming an index
• Passive: Paying a smaller fee but with certainty that the return will be around the index return, depending on tracking error, and minus any further fund costs such as OCF and bid/ask spread

Depending on an investor’s objectives, both active and passive funds have a role to play in a portfolio. Investors will find that passive funds perform best in mature, efficient markets, while active management tends to hold its ground better in emerging or more illiquid markets.