Wednesday, 30 November 2016

Passive vs Active Investing

The issues investors need to get to grips with when looking at index trackers. Any conversation about investing will eventually come round to the active versus passive debate: is it better to pay more for a manager who will take ‘bets’ in the hope of beating the market or to just accept market-like returns and make a big saving on management fees?

There’s no definitive answer to this of course, but the second approach – which is known as index tracking or passive investing – has a strong following in the US and is growing in popularity at an ever increasing rate in the UK and Europe.

Index investing revolves around the view that it is difficult to outperform the market over the long term so attempting to match its performance by tracking it as closely as possible is the best approach. These products have a very simple objective: follow an index’s performance but don’t add to effort or cost in trying to beat it.

There are advantages to passive investing. Tracking an index means that risk is spread across the market, thus reducing the chance of an investor finding themselves overly exposed to one area just because it is the favoured hunting ground of an active investor. History tells us that active managers are by no means guaranteed to get their calls right. This approach also cuts down on research and trading costs, meaning trackers tend to have an automatic head start ahead of their more expensive rivals.

However, there are risks too. Investors in tracking are fully exposed to broad market declines, whereas savvy active fund managers can protect their investors by holding parts of the market they expect to hold up well. They can even up their exposure to cash if they feel particularly threatened.

Moreover, as with any fund, there’s always the risk of picking the wrong product. While in a perfect world all passive funds would be equal, there’s a number of key issues that differentiate them and can make some perform much better than others. Just because you buy an index tracker does not necessarily mean you get index returns. Indeed, sometimes the difference in performance can be significant.

Passive investors typically make use of two kinds of fund: traditional indexed funds (often referred to as trackers) or exchange-traded funds (ETFs).

Trackers are essentially the standard unit trust or open-ended investment company (OEIC) that most investors are familiar with, but they are not actively managed and simply seek to replicate an index. They are bought directly from a fund management company or through a platform.

The aim of an ETF is the same. The key difference is that these products are traded on stock exchanges, meaning unlike unit trusts and OEICs they are priced continually through the day and investors can buy or selling whenever the exchange is open, rather than at limited times. Given that the issue of costs often drives investors to passive funds in the first place, it’s no surprise that this is one of the first things they consider. Costs are of course very important; while some trackers are very cheap, charging less than 0.1 per cent in some cases, others are almost as expensive as active fund managers. However, while a cheap tracker has an automatic head start, this doesn’t mean it will necessarily deliver a better result. Some of the cheapest trackers on the market have been very poor at replicating their index, which in most cases cancels out the cost advantage they had in the first place.

As always seek professional advice from a qualified advier where appropriate.

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