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The cost of investing: Active vs passive funds

By David Norton - October 09, 2014

Are active fund managers worth their high price?

Investment managers of old were modest men who tried their best to make good investment returns for their clients and shareholders through the process known as active management. Through the 1980’s, active management changed to the excess that was typical of this time, and this resulted in a loss of focus on clients' interests and more focus on the active manager's bonus…culminating in the credit crunch in 2007/8. Since then, has much changed? David Norton explores.

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There is now a wider awareness of just how big fund managers' bonuses can be. The economic meltdown has put the importance of major financial institutions and their influencers much more in the public eye. Fund managers, star investment and currency traders, bank CEO’s and Central Bank chiefs are the now seen as the power brokers, with the fate and success of major financial institutions being intrinsically linked to, and often of greater consequence than, entire nations. But, are the active managers any good at managing money?

This question is one which the finance industry pays lots of people, lots of money, to avoid answering. There are very many different investment opportunities available now, and so much noise made about them that it’s difficult to obtain hard facts.

Passive v Active Investing

However, looking on a smaller scale, and the investment management of private client money (average investors trying to make a return on their savings), the growing consensus seems to be that none of the active management professionals are that great, at least not consistently.

The passive (or indexed investment) approach versus active fund manager debate has grabbed headlines in the US for some years. Active investment management is such a widely accepted norm that it is difficult to be objective about it. Millions of people's livelihoods rely on the success (or otherwise) of active managers' investment solutions.

So - what is a passive investment strategy?

It uses index tracking funds which are lower cost than actively managed funds, and operates on the principle that it is very hard to outperform the market (outperforming the market being the principle that active managers rely on).

Free download: Active vs Passive Investing: What are they and what's the difference? »

So what do we know?

A study by Vanguard (admittedly, one of the largest purveyors of passive investment funds) shows the following information:

  • Actively managed funds underperform indexed funds on average after costs.

  • Some actively managed funds can perform far better than indexed funds, but the persistence of these is less reliable than the flip of a coin.

The premise of active funds is that they have skilled managers who can deliver exceptional returns that beat the market, and this is how they justify their higher costs. However, Vanguard's review of active investment funds available to UK investors in 11 different categories found that:

  • Over 50% of such funds failed to beat their own benchmarks in every single category over 15 years.

  • In 10 categories, over 75% of such funds failed to beat their benchmarks.

  • Over 10 years, over 70% of funds lagged the market return in every single category.

  • Over five years, over 50% of funds underperformed in every single category.

But what about the active fund managers national hero and treasure, Neil Woodford who has a genuinely impressive and consistent track record? Surely, he’s not unique? Surely not all fund managers underperform? Can't one just pick a manager with a great track record and a smart strategy, and forget all about average returns?

In answer, there is scant evidence that active fund management beats the market over prolonged periods, once their higher running costs are brought into account. It’s a zero-sum game, where periods of outperformance come hand in hand with periods of underperformance, leading to an average return at best, minus those high costs.

No one doubts that some people exist who can deliver great returns. The problem for investors and financial advisers alike is that these very few active fund managers must be identified before they come to public attention from their success. Once their secret is out it’s too late, everyone jumps on the successful active manager's bandwagon and he becomes a closet index-tracker because his positions are so large.

Free download: Active vs Passive Investing: What are they and what's the difference? »

How then can the average investor select the superior manager?

There’s so many around with so much marketing hype,  that the process is akin to choosing the stocks yourself. In reality the information most necessary for selecting superior investment managers remains inaccessible to nearly every market participant. There are plenty of industry insiders including the legendary active investor Warren Buffet who advises his wife and and ordinary investors to put their money into passive investments. The reason is that passive investing will provide average returns in an efficient way, at a low cost, whereas active funds in the longer term will, in all probability, provide the same average returns but at a higher cost. The effect of compounding costs and charges on investment returns is substantial. Over a 10 year investment period, charges paid to an active fund manager are far greater than the costs of running a passive investment that just tracks the market. 

Many people, being well aware of the lower costs, would still prefer someone at the helm, someone experienced to make the calls to avoid disaster, or indeed gain return and outperform at the right time. But this approach perhaps owe more to wishful thinking than sober sense.