Passive or Active – what’s best?

In today’s article we are going to discuss a topic of investing which seems to still attract a lot of heated attention. The question that remains so fiercely debated within the investment world is of course, is it better to be active or passive? This general debate then leads to the more specific question of whether investors should favour tracker funds over individual equities. Well, clearly there are two arguments to every story and so for the purposes of impartiality we will try our best to be unbiased and look only at the facts. There are a few factors to consider but one of the most important ones is actually quite simple and that is what are your investment objectives? That’s because passive index-tracking funds (commonly known as ‘trackers’) perform a great job for a certain type of investor but doesn’t do so well for anybody else. For a start there are numerous benefits to tracker funds including the fact that they are usually quite cost-effective, simple to understand and easy to implement. In other words, you can usually find a fund to track any established index in the world that you desire and get an overall exposure to that stock market benchmark quickly and easily. This saves you the headache and hours of research that you might otherwise need to spend in identifying those individual companies which might perform well. This means that if either you don’t have the technical ability or experience to be able to pick stocks yourself or you just don’t have the time or inclination to do so, then funds can help to resolve those problems. In effect, you are paying somebody to build an investment portfolio for you. Another advantage is diversification. That’s because investing in funds does away with the extra risk involved in getting one of those singular purchases wrong. Rather than investing in individual companies you are effectively investing in the full list of companies within that index. In the case of the FTSE100 index for example the fund will in essence gain exposure to all 100 companies. That’s great news because by investing across such a large pool of shares you immediately dampen the volatility that is otherwise present within individual shares. In other words, it’s a lower risk form of investing. Then there are costs to consider. If you really were to try and replicate an index and buy each share within it, you would incur huge commissions. In fact, it just wouldn’t be financially viable. Finally, there is the consideration of trying to manage such a portfolio. If you held every company within an index how could you possibly take care of those investments? And if you sold one company then that would upset the balance of the remainder and so the only way to maintain the index would be to either keep all of the companies or sell them all. This would mean that periodically when poor performing companies drop out of the index and new companies join the index, you will need to make the necessary changes to your portfolio which again involves money, time and effort. So far, the argument for passive tracker funds seems pretty compelling, doesn’t it? In fact, by reading back the last few chapters, one might be forgiven in thinking why anybody even bothers to invest in individual shares. Well, that’s because there are some definitely significant downsides to trackers which just can’t be ignored. Firstly, tracker funds are not always what they seem. Some funds may completely mirror an index by investing in every stock within that index (known as ‘fully replicated’ funds), but many don’t. Other tracker funds known as ‘partially replicated’ funds only invest in some of the companies, and therefore don’t give a true picture of the index. And quite often tracker funds don’t actually invest in the underlying equities in any case. Instead they are created through derivatives which give the impression of investing in the underlying assets. Because of this there is something known as a ‘tracking error’ which you need to be aware of. This is where the fund that you thought was supposed to track a particular index actually doesn’t track it very well at all. If you are lucky and the tracking error is low then you should be okay and the return on your fund is likely to mirror the index. However if the tracking error is high, then you might find that at the end of the year the index went up by 10% but your fund only went up by 5%. Tracking errors are typically higher where the costs are higher. You see, funds are not cheap to run. They involve trustees, administrators and custodians, and all of these associated costs have to be taken out of the fund to give a net return, which is therefore going to be less than the index. Then there are the dividends to think about – an index automatically feels the full force of the dividend on the ex-dividend date but the tracker fund won’t receive the benefit of the dividend until at least a few weeks later, on the payment date. This therefore creates a further mismatch in pricing between the fund and the index. This is a problem because to avoid unhappy investors who might look at their index tracker and question why their tracker is performing worse than the index, fund managers try to compensate by being active. This is quite bizarre really because the fund is designed to be easy, simple, cost-effective and passive and yet at the same time, it now has an element of active investment participation from the fund manager. The fund manager is essentially trying to make up for the costs of the funds by not buying every stock in an index. In other words, the whole purpose and the benefits of a passive fund including diversification, dampened volatility and lower risk, is now being undone. This means that the portfolio becomes higher risk. It’s an odd phenomenon. However, there are other challenges that face passive funds over individual share holdings. One of the biggest problems is a complete lack of control. As an investor, control of your money is one of the fundamental principles to abide by, and with a fund you really have none whatsoever. The only thing that you can do is either to sell the fund or buy the fund, that’s it. You can’t make any decision on which stocks go in or out of that fund. Clearly with an index tracker fund, you would hope that the fund invests in all of the constituent parts of the index that it is tracking but as you have seen that’s not always the case. This means that you not always be investing in the things that you were expecting to. The other aspect is fees. Yes, the cost may not be significant but it is annual year in and year out, whereas the cost with an individual equity is once only. This means that over a number of years you are likely to pay much more for an index than buying an individual share. However, by far the greatest disadvantage of funds, and particularly passive funds is performance. A passive fund can only ever expect to generate a decent profit in a bull (rising) market. In either a side-ways moving market and particularly in a falling (bear) market funds have little or no chance of a positive return. And when you take into consideration the tracking error, most funds will actually lose money. That’s not the case with individual shares. With direct share holdings, you can hold a company for as long as it continues to either increase in value or pay you a healthy dividend. The moment that neither of those situations look likely or even if you just feel uncomfortable about that company, you can easily sell and go into cash. With a little patience and some basic judgement skills it’s not that difficult to buy back either into the same company or a different company at a lower price, particularly if the market has fallen in value. This fluidity to investing is what gives people the best return on their cash, it’s what gives the best performance on their portfolios. Yes, it may involve a little more work but you don’t have to be a market perfectionist unless you want to sell at the very top and buy at the very bottom. In fact, you probably shouldn’t even try doing this in any case. But in most cases companies and even entire sectors will usually give very early indicators about when you should consider moving out of them. For example, the utility sector has been under a lot of pressure for at least two years as it has come under pressure from Government and society at large and as renewable and cleaner forms of energy has gained popularity. Similarly, since companies like Amazon have exploded onto the scene making buying online so easy, retail high street companies have come under a lot of pressure. This has resulted in the collapse of many shares and even led to some falling into administration. The point is that by reading the newspaper, watching the television or just walking into your local Blockbuster Video store (remember them), you will have a pretty good idea about the types of companies that you should or shouldn’t be investing in. Of course, direct investing in equities is not for everybody and so you shouldn’t discount the power of passive tracker funds, particularly in emerging or foreign markets where you are less likely to have specialist knowledge in that area. But overall our view is that direct shareholdings, particularly if you know what you are doing, is far advantageous than sticking your money into a tracker. Like most things in life, it really comes down to how much you are prepared to put into your investments which will determine what you get out of them.