Much of the investment community has debated the topic of active vs passive investing for quite some time now. Looking at the commentary, for example Buffet, who regularly recommends using a tracker over active investing in his letters, and actual fund allocations, eg the huge increase in passive fund allocation over the last few decades, it would seem many are on the side of passive investing.
Given we are all personally active investors here, the relevance of this debate is perhaps somewhat limited – however, its an interesting topic to consider for any investor.
Active investing – investing in funds or yourself selecting investments based on an independent assessment of each investment’s worth, for example, trying to seek investments that meet a certain criteria (like ‘good value’ or ‘high growth stocks’). Active investors are trying to “beat the market,” or outperform the universe of investments in which they operate (eg for UK large cap investors, the FTSE 100 or FTSE 350).
Passive investing – investing funds in which explicitly avoid making judgements over the quality of a specific investment, and instead seek to match or replicate a broad basket of investments – usually a benchmark like the FTSE 100 or FTSE 350.
One of the issues which has led passive funds to increase in popularity has been 1) the impact of fees on a compounding return 2) poor active fund manager performance. Below is a table highlighting how, assuming a 5% gross return, a 0.5% pts difference in costs can lead to a massive 15% pt difference in capital in year 30.
|Passive, 5% and 0.5% Cost||Active, 5% and 1.0% Cost|
|Year||Annual Return||Absolute Return (index 100)||Annual Return||Absolute Return (index 100)||% Difference|
Prior to the 1980s or 1990s, it was not possible to replicate an index, and only in the last decade or so have investors been able to replicate an index with so little cost. But given it is now achievable, the level of market beating performance an active manager requires to outweigh the impact of their fees has grown. In the meantime, active manager performance has been poor, with fewer managers beating the benchmark.
What does this mean for private investors?
- Be wary of fees – this isn’t new news, but its important to acknowledge the impact of your own trading fees (and to some extent, your own time) when investing. You might beat the market, but if you give it all back in the form of trading costs, you might as well have put it in a tracker and saved yourself the trouble!
- Beating the market – we’re all here to make returns and increase our capital. Be realistic about your long-term ability to generate capital appreciation. Unlike years ago, it is possible to replicate the index at very, very low costs – we should always put ourselves under the microscope and confirm or otherwise our ability to beat the market.
- Consider the alternatives – given the possibility for easy and cheap passive investing exists now – and can be traded in and out of very quickly – there may be times when it makes sense to hold some of your portfolio in a tracker fund.