Head to head: Active vs passive investing

Published by on 18 July 2016.
Last updated on 20 July 2016

Passive funds, also called index tracker funds, aim to replicate the performance of a stock market index. Active funds, run by professional fund managers, aim to produce superior returns to index tracker funds.

To learn about investing basics, make sure to read our beginner's guide to investing in the stock market.

Passive champion:

Robin Powell (pictured below) is a freelance journalist and blogs as The Evidence-Based Investor at Evidenceinvestor.co.uk.

To me, the question is not so much why you should use passive funds, as why you should avoid actively managed funds.

Active funds sound great. We all like to think we can beat the market. The industry has an army of advertisers and PR consultants telling us that all we need to do is pick this or that fund. Journalists too often prefer to write about active management; reminding readers every week they’d be better off indexing is not a great way to boost circulation.

But the evidence shows that while an active manager may be able to outperform over, say, two or three years, only around 1% of funds succeed in doing so consistently over any meaningful period of time – such as 20 years. That’s no more than you’d expect from random chance. 

After all, new investors today are likely to be saving for 40, 50 years or more. Very few active funds available today will still be around 40 years from now, and even those that are will have had several changes of fund manager in the meantime.

Of course, we can all see who the ‘star’ managers have been in the past. But past performance is no guide to future returns. The challenge is to identify the winners in advance, and the research clearly demonstrates that it’s almost impossible to do.

An ongoing study by The Pensions Institute, based at Cass Business School in London, has concluded that the vast majority of UK fund managers are “genuinely unskilled”, and that even those very few managers who do beat the market consistently “extract the whole of this superior performance for themselves via their fees, leaving nothing for investors”.

Active funds don’t offer outperformance; they merely offer the possibility of outperformance. What we rarely hear about is the likelihood of underperformance.

The industry is very clever at disguising the fees and charges investors pay; often the total is to two or three times the figure advertised.

Very few people, including investment professionals, fully appreciate the staggering long-term impact of compounded costs on investment returns. The investment writer Lars Kroijer puts the difference in cost of saving for retirement in active funds as opposed to passive at the equivalent of seven Porsche cars. Most investors will never drive a Porsche, but I’m told it’s the car of choice for people who manage their money.

When you add everything up, the average UK investor pays about 1.5% or more to invest in an active fund — and that’s before the cost of advice. It’s bonkers. Why pay 1.5% for funds that will likely trail the index when you can buy a fund for 0.1% that will track it? That’s right — 15 times cheaper.

Of course, there are plenty of advisers and consultants out there who will try to persuade you that active is best. Their business models are built on the idea that they have the magic sauce that no one else possesses. It’s a beguiling message. But I’ve yet to meet anyone with a 20-year track record who can prove that his or her clients would not have been better off indexing.

Active champion:

Alan Steel (pictured below), chairman of Alan Steel Asset Management has been an independent financial adviser (IFA) for more than 40 years and has survived five stock market crashes.

Nine months after I became an IFA in January 1973, world stock markets crashed, with the FT 30 Index falling over 70% in 14 months. It took a long, long time for savers to get over it. Between 1965 and 1982, US and UK stock markets went nowhere. Then, when most pundits least expected it, a secular bull market – a positive, long-term trend upwards for the stock market – began. Despite falls in 1984, 1987, the early 1990s and 1998, those who stayed invested did rather well. And then another two 50% stock market falls happened in the past 15 years.

So where did the idea for UK index trackers came from? Who fancies tracking big falls? I spoke to a statistician who led the product development team at Legal & General from 1987 to 2001. He recalls L&G spotted that most funds bought by the big final salary pension schemes were simply ‘closet trackers’, charging full price for trying to keep close to the index.

So in 1992 L&G devised cheap index trackers to manage around half the pensions scheme moneys, slashing charges in the process. L&G cleaned up. Its flagship tracker fund is now almost £5 billion in size. But what about retail investors?

Step forward Richard Branson. Spotting an opportunity to attack overcharged poorly performing active funds, the Virgin All Share Tracker launched in 1995 with a 1% annual charge. £2.5 billion sits in it today.

But neither fund has done well since against well-managed funds run by hard working managers, even after charges.

Despite this, we’re increasingly assured that “you can’t beat a tracker”.  Now I concede that for the US stock market that’s true. The spread of companies in the S&P 500 Index of large American companies makes it hard to beat. The top 20 stocks only make up 27% of the total. However, the UK stock market is an entirely different story. Here, the top 20 stocks produce 50% of total performance.

Theorists say it’s a mathematical fact cheap trackers outperform dearer active funds. Sure… if you invest exactly as the index does. 

But investors shouldn’t settle for average. It’s not easy spotting winners, but it’s well worth it. My pension fund has US trackers in it, but no UK ones.

Check out the performance numbers of almost the entire UK equity income fund sector versus trackers over one, three, five, 10, and 20 years.

The great passionate investors advise us to “buy low, sell high”. A capital weighted index, in which larger companies carry higher percentage weightings does the opposite – as a company increases in value the index buys more of it. 

Passive and passion share the first five letters, but in life, like investment, they’re at opposite ends of the spectrum.

Moneywise verdict:

There are strong arguments on both sides of this debate. Moneywise’s First 50 Funds, which you can see in the July edition of our magazine and which will be online soon, includes 20 passive funds and 30 active funds. We think investors should mix both approaches in their portfolios, using low-cost passives for the core of their portfolios and then adding in satellite active funds to try to enhance performance.