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Active vs passive funds – why not use best of both?

When buying investment funds there are two main options, active and passive, but how they can complement one another in a portfolio?

| 5 min read

Active vs passive funds – which offers the best opportunities for investors? In fund management circles, this debate never seems to end. As a quick reminder, active funds employ managers to try and select the best performing investments, whereas passive investments – or ‘trackers’ – simply aim to replicate the performance of an index, say, the FTSE 100, usually by holding all or most of the constituents.

The active vs passive debate

Fund managers discussing active vs passive debate at a boardroom table

Many industry professionals are staunch advocates of active investing, claiming that a selective approach leads to better ‘risk-adjusted’ returns. They also make the point that passive strategies are effectively getting a ‘free ride’ on markets. ‘Price discovery’ is achieved through the research of active investors, whereas passive investors simply buy the market paying no heed to valuation nor prospects. Meanwhile, passive enthusiasts point to the high failure rate of active strategies, and urge that investors should maximise returns by minimising costs – something that is easy to do with inexpensive tracker funds.

Our view is nuanced. We believe there is a place for both types of investment in portfolios and there is no need to wed yourself to one approach or the other.

1. Passive investment funds can offer long-term reliability

Passives should generally be considered the ‘default’ fund option in the absence of a genuinely strong reason to use an active alternative. Trackers represent a particularly good strategy for areas where managers consistently struggle to beat the index – often large, well-researched markets. The US market would be a prime example and investors will have done well in recent years simply to buy an S&P 500 tracker. It is worth noting that the inexorable rise of a cluster of large tech and e-commerce businesses has overwhelmingly driven the US market over the past decade, and should these have a tougher time then a standard passive fund could struggle. However, in the absence of a crystal ball and in recognition that it’s really difficult for an active manager to consistently have an edge over Wall Street, passive funds remain a strong option for this market.

2. Actively managed funds may present unique opportunities

Yet there are also areas where we would hesitate to take a passive route. UK smaller companies is one area where active managers have added considerable value over the years. Why is this? We believe it’s the ‘inefficiency’ of the market. Relatively little proprietary research is taking place compared to the multitude of analysts poring over US behemoths. Fund managers getting under the bonnet of these businesses are more likely to discover anomalies and opportunities missed by others. Uncovering stocks or areas that the wider market doesn’t fully appreciate is precisely where active management works best and cost, although important, may be a second order consideration. Often more pivotal to returns is the expertise of the manager and their team.

3. Active and passive funds can work together in a portfolio

At Charles Stanley, our managers building portfolios are neither wedded to active nor passive strategies for fund choices and can cherry pick the optimum strategy for particular needs. If they think there are more inefficiencies for active managers to exploit, they allocate more towards active. We are currently investing in active funds in Asian and Emerging Markets where we believe there is more opportunity for active managers to add value, whereas in developed markets we are more biased towards low-cost passive funds outside some more thematic strategies.

More considerations for actively managed funds

There are also investment frontiers beyond the reach of passives that are well worth considering for diversification. For instance, ‘illiquid’ areas such as physical property and infrastructure can be accessed through specialist investment trusts. The ‘closed ended’ structure of an investment trust, which is actively managed, is often most appropriate for accessing esoteric asset classes, and the only credible option for areas where liquidity (the ease of buying and selling the underlying investment) is problematic.

Private equity is also a major area where active management is largely the only route. Stock markets don’t have the monopoly on investment opportunities. Some of the fastest growing companies and investments with exciting potential are in the hands of private holders, often founders and exclusive bands of early investors in the case of relatively new companies. Private equity investment trusts buy into unlisted companies and other areas that would otherwise be very difficult to access. Although it can be higher risk, its potentially a source of decent returns as sometimes the growth a company enjoys is strongest in its pre-stock market life – if it ever lists on a market all.

Diversification is key

Diversification

By combining passive funds in more generalist areas with more specialist active funds, pragmatic investors can take a ‘best of both’ approach. This should result in genuinely diversified portfolios that maximise opportunity as well as control cost. There is no need to wed yourself to one side of the active vs passive debate.

Looking for investment ideas? Explore our Preferred List for a curated list of funds and trusts that are overseen by experts.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Investment ideas

Looking for investment ideas? Explore our Preferred List for a curated list of funds and trusts that are overseen by experts.

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Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus.

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