Active vs. Passive funds

7th 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.

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