One of the most fundamental and enduring investment debates is over active versus passive management. Which consistently offers the best returns over time? Which will ultimately provide investors with the best possibility of achieving financial goals?
Passive managers buy and hold portfolios that are designed to replicate the market, or a large proportion of it. By buying each stock in an index, or a broad representation of the stocks in an index, passive managers generally deliver returns that match their index, so in theory at least there will be no nasty surprises.
In contrast, active managers seek to build portfolios that outperform a market benchmark, usually through a combination of stock selection and market timing. In some years, some active managers will succeed in outperforming their benchmark, while others will fail.
So why would anyone settle for the average returns of passive management when they can obtain above-average returns by selecting above-average managers?
Passive investing proponents argue that markets are efficient - that is, that the market takes into account all the available information about any particular security and price it accordingly. So they believe there is little room to take advantage of mispricing because prices already reflect true value.
But the proponents of active management argue that the market is not completely efficient, allowing smart investment managers to best the market. And a number of managers clearly do so every year. But as the availability of information increases every year, say passive managers, so the efficiency will increase and it will become more difficult to beat the market.
Passive investors also cite the laws of arithmetic. It is a given that the average return of actively managed portfolios will equal the return of the market. It is impossible for the majority of investors to outperform the market so half of these funds should beat it and the other half should under perform it. If you add in the costs of trading, administration and management fees, fewer than half of actively managed funds can possibly beat the markets over time.
The key advantage of active management, the potential to beat the market, is only useful to individual investors if they consistently choose the winning managers. With no systematic, reliable way of ensuring that your choice of active manager will outperform the market, in the end you have to gamble on who you think will deliver the best returns.
It must be remembered that costs matter. Paying a total expense ratio of 2 or 3 per cent when equity returns are 8 per cent effectively wipes out the equity premium. This reinforces the need to choose managers who will outperform.
The costs of passive funds are low because the fund is not being "actively managed". But there is still an element of manager risk. Tracking methods vary, ranging from full replication - holding every stock in the index in proportion, to partial replication - holding a sample of the index, in order to reduce dealing costs. Timing of buying and selling can also affect performance.
Despite these differences, when you choose the passive route you know in advance that you will receive a return approximate to section of the market the fund is tracking. Over time, this has been a good return. And, as the studies show, the much lower costs of tracker funds will ensure that they will generally beat two-thirds of actively managed trusts.
If you choose an actively managed fund you will have to monitor the fund's performance, and make sure you are not left hanging when a star manager leaves. It is true, though, that passive funds are not as flexible as their active counterparts, and do not have star managers who can hop nimbly out of share that looks as if it is about to fall off a cliff.
