Should you invest actively or passively?

4 min Read Published: 10 Aug 2010

Photographer: federico stevanin For every investor there comes a point in time, usually after reviewing their portfolio performance, when they question whether it’s worth paying a fund manager to try and beat the market, or whether they would be better off investing their portfolio passively.

If you make a quick search of the internet, or the investment section of a book store, you’ll find that the general consensus of opinion is that active fund managers fail to beat their respective index, regardless of the sector.

In John Authers’ article in the FT he points out that there are two likely reasons why fund managers fail to outperform an index. One reason being that markets tend to be efficient, so that prices tend to reflect all that is known about the company/market in question, including the most recent information. Therefore, in the long-run a manager will only outperform the index by luck. Based on this notion an active investment manager would have more chance outperforming the index of a less inefficient market, i.e. one that is less well researched which could offer opportunities for well researched investors.

The other crucial reason for underperformance is the cost involved in active management. If a manager is trying to beat the market then once they deduct their management fees it is almost inevitable that they will underperform ‘passive’ funds which purely try to match the index, and not beat it. Crucially, the large mutual funds in aggregate are essentially ‘the market’ as they exert the greatest influence on prices due to volume. Therefore surely it follows that their performance will by definition match ‘the market’ but overall returns will undershoot once their fees are deducted? But as John Authers points out ‘’ Any argument based on the notion that markets are “efficient” is hard to sustain after the crisis of 2008, when at one point virtually all the stock markets in the world lost 20 per cent in one week. So the active versus passive debate is subtler than first appears.’’

So he goes on to refer to a study by Jane Li of BNP Parabis’s FundQuest which looked at 30,000 US equity funds running over $7,000bn between them. But before I elaborate any more, here’s a quick note about two concepts crucial to assessing an investment manager’s performance, namely alpha and beta

So what is alpha?

In simple terms alpha is a figure which measures a manager’s apparent skill at picking the right investment opportunities. So a fund with a positive alpha shows that the manager is obviously doing something right as he’s generating returns ahead of what you would expect, given the returns of the wider market.

And what about beta?

Beta measures a fund’s sensitivity to the general market in which it operates. The market always has a beta of 1 by definition. So if a fund also had a beta of 1 that would mean that if the market rose by 5% then so should the fund. If the fund has a beta of -1 then as the market rises so the fund falls. ‘’ A well-managed index fund will have a beta of exactly 1; funds that outperform the market when it does well but do even worse when the market is going down will have a beta above 1.’’

So what did FundQuest find out?

Well, looking at historical data they found that equity funds have a beta of 0.93 which indicates that they are heavily led by what the market is doing, but the active manager does take slightly less risk than the market. But interestingly during 2008, when things were pretty bad in the investment world, active managers had a beta of 1.01. ‘’So they were over exposed to the market just as it collapsed’’.

Looking at alpha over the last 30 years, ‘’active managers had positive alpha in the bull markets, but negative alpha in bear markets’’. This suggests that active managers take extra risk and follow the latest trends when things are going badly in pursuit of returns. When the going’s good investment managers seem to do well but when things go badly they underperform simple indexed passive funds.

Not exactly what most investors would want to pay for.

Interestingly the research actually showed that supposedly less efficient markets, such as Latin American equities, saw the most negative alpha.

So a fund manager's underperformance can't simply be put down to a combination of costs and market efficiencies. How their investment style/behaviour and risk appetite change in differing market conditions plays a large part.

FundQuest concluded that the active funds most likely to outperform were those with longer manager tenures ‘’suggesting that truly skilled managers who are left alone to do their job will reward their investors. If the same manager is in place, past success may help predict performance in future’’. Authers concludes that ‘’most investors should base themselves around index funds.’’

But if you are keen to start investing in indexed funds and Exchange Traded Funds (ETFs) we suggest you do some reading around the subject first. Passive and Active investment styles don’t have to be mutually exclusive and there is an argument for a core of good quality active managers surrounded by a selection of passive investments. Also make sure you know what you are getting when buying an index tracker or ETF. You may think that you are investing in the fortunes of the UK economy as a whole by buying a FTSE 100 tracker/ETF. However given that a significant proportion of the FTSE 100 Index has been made up of banks and other financials your portfolio will historically had an over dependence on this particular sector. Add into the mix that the majority of returns from the FTSE 100 companies are derived from overseas and you can see that you need to be happy you know what exactly you are buying. An alternative approach is to buy ETFs which track particular sectors or industries.

If you want to find out more about passive investing then have a look at the Financial Times Guide to Exchange Traded Funds and Index Funds: How to Use Tracker Funds in Your Investment Portfoliofor a bit of bed time reading.