Active vs. Passive funds
- 7 June 2012
The debate over active and passively managed investments is one that continues to claim much attention and arguments can be clearly made for either side of the fence you sit. We are often led to believe that stock markets are efficient, and if this holds true the argument for passive investing and an index fund would suffice. However, as we have seen over time, not all markets are efficient and valuation anomalies do occur; it is for these reasons that the argument for active management persists. Personally, I believe there is a place for both, depending on the investment objective of the investor.
For those investors seeking exposure to the stock markets without wanting to identify and research the vast investment universe and keep costs to a minimum, they are more likely to be suited to the passive index tracking approach of either a tracker style fund or an exchange traded fund (ETF).
If passive management is the preferred choice investors need to ensure they understand how the index replication is taking place. Given the size and scale of many of the indicies, full replication, which requires holding every stock in proportion to its weighting within the index, is near impossible as well as potentially being far too expensive. So many passive strategies adopt partial or optimised replication, holding the key principle drivers of an index's performance or aiming to have its performance replicated through the use of derivatives.
Investors should research how the tracker is constructed. In respect of ETFs, depending which index the investment is replicating, investors need to fully appreciate that the risk may be greater than initially thought given the potential for counterparty risk. This is because there are a number of ETFs available whereby the actual investment contains counterparty risk and the underlying holdings may not equate exactly to the investment chosen.
The argument for active management is that a manager has the ability to identify and seek out those equity valuations which they believe are out of kilter with the markets expectations. They therefore look to construct a portfolio which will outperform and generate excess returns when compared to the overall market. Such analysis should not simply be focussed on the positive returns but just as importantly on the downside. We fully appreciate that markets are volatile and it's the downside protection and damage limitation to potential losses that is just as important.
More on Mindful Money:
To receive our free daily newsletter sign up here.
Mindful money Mortgage Tool Box
Looking To Re-mortgage
How Much Could You Borrow
How Much Is Your Home Worth
Find a Mortgage Advisor
- The pension chance of a lifetime? Taking a small pension pot as cash and topping up the state pension could double what an annuity would give
- Just weeks to go until pension reforms, but still no phone number for guidance service
- Experts share their views on the Woodford Patient Capital Trust
- Too many DIY investors are running high-risk portfolios
- Post Office ISA allows mix of fixed and variable rates. Shawbrook launches cash ISAs.
- UK economic growth confirmed at 0.5% for final three months of 2014
- The worst cash ISAs named and shamed - make sure you switch
- Royal Bank of Scotland posts £3.5bn loss for 2014
- FTSE 100 breaks through to all-time high at last
- Following 2015's market highs, should investors be preparing for a correction?