The merits of active & passive: which is the safer bet?

30 June 2020

In the last decade, there’s been a fundamental shift to passive investment strategies. Is that a good or a bad thing? The big draw of passive management is that you don’t pay as much in management fees, and that can make a big difference as fees can chew up a chunk of your return. The cost of investing in Exchange Traded Funds (ETFs) and other passive vehicles has reduced dramatically, and cost is one of the determinants of long-term investment performance; the lower the cost, the greater the chances of better performance.

If you’re a passive investor, your goal is to match the performance of certain market indexes, rather than trying to outperform them. Passive managers simply seek to replicate the positions in a market index, in the proportion they are held in that index and the fees are generally much lower than in active management. With active investing, you pay research analysts and portfolio managers to manage the strategy, making it more expensive, and many active managers fail to beat the index after accounting for expenses.

Depending on the market, it can be difficult for active managers to outperform indices, and so passive investing may seem to be the better bet in the long term. Active management does add value, but, depending on the figures involved, the fees can offset the benefit to the end investor. The basic idea is that however inefficient a market, the average active investor will struggle to outperform the index, given that the index performance is the average of all returns.

When markets are efficient, it’s even harder for active managers to outperform. Passive investments tend to track a particular market and as a result tend to have a larger investment in the larger stocks such as Amazon, Apple, Facebook etc. (the FAANGs), as these represent a greater proportion of the index. This is where the recent market growth has been and if you’re invested in a passive fund tracking these large companies, you’ll have exposure to these holdings and will have seen good performance.

For these reasons, passive investing may seem to be the more savvy and safer bet, but this isn’t the whole picture. Too many investors rely on passive strategies alone, and when market efficiency suffers, opportunities for active managers emerge. And what about periods of market stress, when outperformance can be most critical for investors?

In certain market conditions, active management will outperform passive as active managers are not constrained by an index and can alter their holdings to reflect the opportunities available. For example, active managers in a UK wide mandate may invest more in smaller companies relative to the market average and so avoid exposure to larger companies when they feel they may underperform. With passive investments, you could be missing out on sectors that may generate a better return over a particular time frame whereas the active manager can make a choice to select or avoid sectors that are outperforming or disrupted in times of market stress.

It’s worth bearing in mind that some of the more valuable trades are made as a result of building up a position in an unloved company or sector and you can’t beat the market if you’re set up to track it.

Therefore, on one hand, active investments can successfully exploit market inefficiencies by well-resourced, skilled managers but on the other hand, with passive investments, the inability to exploit market inefficiencies may be offset by the lower costs. The effectiveness of passive investing is related to how efficient a market is, while active management can take advantage of inefficient markets.

The investment climate is clearly a key determinant when choosing an investment strategy. Active and passive approaches tend to benefit investors in different markets. Volatility in the market creates opportunities for active managers; a fund manager gets outperformance when he knows what to invest in, and passive strategies may be better when specific securities within the market are moving in unison. For the experienced investor, mixing both passive and active strategies could be the way to go, leveraging the most valuable attributes of each and making the most of the ever-fluctuating market.

The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use. This article is for information only and should not be deemed as advice