Different types of investment Active vs passive investment
If you’re placing your money into an investment fund, there are two main strategies you’ll encounter - active management and passive management.
Debate has raged over the years as to which is the most effective way to invest your money and, certainly, within the unit trust and OEIC space, your choice of actively managed funds heavily outweighs passive funds. There are over 2,000 actively managed funds and only 70 passive funds listed by the Investment Management Association.
However, access to passive investment strategies has risen dramatically in the past few years with the introduction of exchange traded funds (ETFs) to the mainstream.
What is active management?
Actively managed investment funds are, like their namesake, run by a professional fund manager or investment research team, who make all the investment decisions, like which companies to invest in or when to buy and sell different assets, on your behalf. They have extensive access to research in different markets, sectors and often meet with companies to analyse and assess their prospects before making a decision to invest.
The aim with active management is to deliver a return that is superior to the stock market that the companies sit within. An actively managed fund can offer you the potential for much higher returns than what a particular market is already providing.
It also means that you have somebody tactically managing your money, so when a particular sector looks like it might be on the up, or one region starts to suffer, the fund manager can move your money accordingly to expose you to this growth or shield you from potential losses.
How does this differ from passive management?
Passive investment funds will simply track a market, and charge far less in comparison. The funds are essentially run by computer and will buy all of the assets in a particular market, or the majority, to give you a return that reflects how the market is performing. Find out more about passively managed funds in our guide to understanding tracker funds and ETFs.
What are the problems with active management?
The fact of the matter is that not many fund managers manage to beat the stock market to which their investment selection is linked. For example, analysis of the UK All Companies sector at the end of 2010 showed that only 24% of actively managed funds managed to beat the benchmark stock market (the FTSE All Share) over the past decade.
So basically, there’s a 75% chance you could end up with a fund that is not delivering you the return you could get by simply tracking the index with a passive fund.
One of the biggest drags on this performance is costs. For the privilege of getting an expert fund manager, you have to pay much higher fees than a passive investment fund. The average total expense ratio (TER, or total annual cost of an actively managed fund) is 1.67%.
So, a fund manager has to deliver nearly an extra 2% in annual return, as well as beating benchmark (the market that acts as a equivalent comparison for performance) in order to prove his or her value. Many active fund managers simply cannot justify these high costs with outperformance. You can learn more about this in our guide to fund charges.
In almost all cases, you still have to pay an annual fee even if the fund manager doesn’t outperform its benchmark. This might be barely acceptable if the fund had returned 7% in comparison to 7.5% from the stock market, but what about if it had lost money? A loss of 2% could be doubled to 4% and you’ve no choice but to pay it. We’ve yet to see an actively managed fund that will waive its annual fee if it underperforms.
Should you invest in actively managed funds at all?
If you pick the right actively managed fund, you could make much more money than by simply investing in a tracker fund or ETF. There are some very skilled managers, who have built up reputations of consistent high returns and can be worth the fees you pay for them.
And, indeed, your investment needs and goals might require you to achieve higher returns and a good active manager can, potentially, help you towards this. However, with such an abundance of actively managed funds out there, knowing who is the best performer can be tricky.
There are data analysts and research companies that give actively managed funds ratings, based on their past performance and costs, that can give you an idea of some of the better funds available. Companies like Morningstar and Standard & Poor’s conduct face to face interviews with fund managers to give a qualitative rating, assessing their investment style and future strategies. These can be a good starting point to discovering the better funds but they have been wrong in the past, so don’t set all your store by them.
Some areas of investment are much better suited to active rather than passive management. Property funds, for example, buy commercial properties and pay returns based up rental income and increases in capital value of the properties. A tracker fund simply cannot do this and it may be valuable to invest in an actively managed property fund.
An active manager might also be useful in more specialised areas, like technology, healthcare, smaller companies or emerging markets like China, where expert knowledge can help to seek out value.