It doesn’t have to be active vs passive investment

While investors and commentators alike may come down firmly on one or other side of active vs passive investment, the reality is that each approach has its merits and both may have a place in a portfolio.

What is active investing? What is a passive investment?

With an active fund, a fund manager will use their skill and experience to pick those stocks they believe will produce the strongest returns over time. Their goal is to outperform a benchmark, which may be an index, inflation or competitor funds.

The alternative is a passive investment, meaning one that ‘tracks’ an index, such as the FTSE 100 or S&P 500. This might be an Exchange Traded Fund (ETF), or an open-ended tracker fund containing a representative sample of assets from the index, offering diversified access to markets. However, it usually means that you’re getting exposure to the largest stocks in a particular stock market, which may not be where the exciting growth lies. The goal is to achieve the same performance as the index so there is no prospect of outperformance.

Active managers can take advantage of opportunities or try to protect returns from potential harm, selling out of vulnerable shares, moving into more defensive areas or buying up bargains. Passive funds have no choice but to stay put and wait things out.

While active funds tend to cost more than passive, you are paying for that active fund management and the potential outperformance. Fund performance is never guaranteed however, and active funds can underperform a benchmark too.

The popularity of passive funds is based on several key factors

The most recent UK Investment Association annual survey showed that passive funds accounted for around 30% of all UK assets under management in June 2020, up from 20% in June 2015.

Perhaps surprisingly, money flowing into passive (index) funds has remained resilient even during periods when stock markets have fallen. According to the 2020 UK Investment Association report, index funds in March 2020 (when markets plunged in response to the emerging coronavirus pandemic) saw “positive net sales of £467 million against an outflow of £10.1 billion from active funds”.

Passive funds tend to be cheaper than active funds at a time when the cost of investing is under scrutiny. A total expense ratio of around 0.1% or 0.2% is common.

They are readily available through investment platforms and offer an increasingly broad choice: the ETF boom has brought passive options for fixed income and commodities, along with specialist sectors and factors (growth, income or value, for example).

However, a significant reason for the recent success of passive funds is the performance of key indices. The S&P 500, for example, increased by an average of around 16% each year between mid-2016 and mid-2021, fuelled by the astonishing success of the large global technology companies – Amazon, Alphabet, Facebook, Microsoft and Apple. In many cases, investors simply haven’t felt the need to look elsewhere.

Market changes could be shifting the balance towards active investing

The major technology stocks that dominate many of the global stock market indices have been driven by a combination of low interest rates, high earnings and, more recently, the need for technology solutions during the pandemic.

However, as inflation picks up in the wake of economic recovery, interest rate rises become more likely. The long-term cash flows of the large technology companies become less valuable. This has been seen in share price weakness from the technology giants. At the same time, ‘value’ parts of the market have started to pick up once again. These are less well-represented in the indices but perhaps more likely to be selected for investment by active fund managers.

Equally, many investors are now demanding that their fund managers take a greater interest in the environmental and social aspects of their investment and make decisions based on them. While this is not impossible for passive managers, it is more difficult. Again, this may favour active managers in the longer term.

Moving on from active investing versus passive investing

While the battle lines of active vs passive investment are often tightly drawn, the reality is that there is a place for both in a portfolio. Active funds tend to work well in ‘inefficient’ markets where securities may be mispriced. This includes areas such as smaller companies or emerging markets. They may arguably work better in corporate bonds, where indices tend to be skewed to those companies or governments with the most debt – a bad starting point for any investment.

In contrast, passive funds tend to work best in large, liquid markets, where pricing is efficient, such as the US. They may also work well in areas where it is difficult for an active manager to add value, such as government bonds.

A final point worth noting is that it is important not just to consider the costs of the fund, but also the costs of the platform you invest though. For a minimum investment of £100 the Fineco platform offers simple, transparent pricing with a maximum annual funds platform fee of 0.25%.