Passive vs Active - can there ever be a winner?

Passive vs Active – will investing’s title fight ever declare a winner?

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Passive or Active – which the better investment strategy? This long-running debate is the investing world's equivalent to a world heavyweight title fight and the ultimate question for investors everywhere, whether rookie or expert, or high, or low net-worth.

So what’s it all about, and can there ever be a winner?

Active investing, where a fund manager picks the stocks & shares they think will do best, is the more traditional approach. Using years of accumulated knowledge and experience (and often a little bit of guesswork, too) active fund managers try to 'beat the market' by picking individual company stocks that they think will do best for investors. 'Beat the market’ simply means they need to get a better return than the market does overall – be that the FTSE 100, Dow Jones or another index – which, is a bit of a no-brainer, because if they don’t, their clients might as well have just invested in a market tracker and saved significantly on their fees. Suffice to say, the pressure is on to pick the winners.

Unfortunately, picking the winners sounds a lot easier than it actually is. Research shows that over the past five years* a staggering 89% of fund managers failed to beat the market each year – getting less return for their clients than if they’d just bought a simple market tracker. But that's not all. Even if you do manage to beat the odds and choose one of those 11% of fund managers who do out-fox the market, research† shows that they're no more likely to do so next year, or any subsequent year. In other words, picking the best fund manager is just as difficult as picking the best stocks & shares. So, the only thing you can really be sure of with active investing is the managers' high fees – after all, those, large salaries and bonuses have to come from somewhere!

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Passive investing is the more modern approach, emerging in the 1970s as a remedy to investors’ frustrations with active fund performance. Originally known as index funds, they’re now more commonly called tracker funds, Exchange-Traded Funds (ETFs) or Mutual Funds. They work by tracking a market index, like the FTSE 100, thereby linking investors' performance directly to that of all of the companies in that market, rather than just one or two. In the case of the FTSE 100, it’s the 100 biggest publicly-traded companies in the UK, names like Aviva, Legal & General and Rolls-Royce Group. In practice this means instead of pinning your hopes (and money) on two or three companies, you back them all on the basis that some will have a bad year, while others will have a good, or very good year. The theory is, that the positive returns will cancel out the negative returns and the market ends the year with positive growth for investors, which historical figures show, more often than not, it does.

It’s the investing equivalent of backing every horse in the Grand National and it's why passive investing is generally seen as a steadier and less risky approach. But wait, buying the whole market sounds expensive, right? Bizarrely though, it's actually cheaper. It’s down to far lower service fees and charges paid for passive investing, as a result of the fewer fund managers and overheads required to operate. As if that wasn't enough, research by Morningstar1 shows that the cheaper the passive fund is, the more likely it is to give you a better return on your money - so in the investing world, cheaper really is better.

So the verdict? Well, Active investing may have a place for certain investment goals, but if you want a low-cost, lower-risk, steady long-term investment strategy that will give you good overall returns, then passive investing deals the knock-out punch.

But don't just take our word for it. Some of the world's most successful investors have more recently come out in support of passive investing, including, notably, Warren Buffett, who told Berkshire Hathaway shareholders in 2014 that he would encourage his wife to invest her inheritance in ‘a simple low-cost index fund’. Buffett's $60 billion fortune may not have come entirely from a passive investing strategy, but when the world's most successful investor gives you advice, you'd do well to listen!

 

Please remember that the value of your investments can go down as well as up and you can get back less than invested.

* Active large-cap fund manager’s performance 2010 – 2015. Source: S&P500 Indices Scorecard 2015. Link

† CNN Money 15 December 2014 link

1Source: Morningstar 5 May 2016: link

The comments and opinions expressed in this article are the author's own and should not be taken as financial advice from Wealthify.

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