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Styles of Investing; Active or Passive

active and passive investing

Before I became a financial planner, investing was all about making money and buying a ‘hot stock’, 25 years later, I reflect on my naivety and appreciate how others may also be thinking this and asking themselves what is the right way to invest?

Over the years there has been so much research in how stock markets work, this makes sense since there’s a lot of money at stake, it seems sensible to understand it.  You’re unlikely to trust your neighbour on medical decisions, preferring to rely on a qualified doctor, so why would you trust your neighbour over your qualified financial planner, or what some of the leading business schools have been telling us for decades, on investment decisions?

There are, at a top level, two ways to access the stock market; directly by buying a share yourself, or via a fund, which is a collection of shares, managed by a fund manager.  If we agree that you want to entrust an expert to manage your investments i.e. a fund manager, because of the benefits this brings, you have a choice in the type of manager you choose, as they manage money differently;

  • They can manage your money actively, or
  • They can manage your money passively

Active vs Passive Investing

After reading this ask yourself which would you prefer, an actively managed fund, or a passive fund?  Surely, all our life we have been taught that doing something i.e. being active, is better than doing nothing, i.e. being passive, so why would investing be any different?

I think this is a reason so many people have chosen active management in the past, however recently we have seen more and more institutional (big players) and retail (you and me) investors buy passive funds.

Buyers of active funds say things like the fund managers are entrepreneurs, they believe in capitalism and making money, they surely know what they are doing.  The passive guys just ‘buy and hope’.

Nothing could be further from the truth, and after decades of research and hundreds, possibly thousands of academic studies conclude that it’s too difficult, to consistently outperform the stock market or in another way, active funds are unable to consistently outperform passive funds.  I even wrote an article about a $1m bet Warren Buffett placed to prove this.

But rather than tell you, let me try to explain the differences and how each works.

How the managers work

The manager of the fund has a mandate which explains what and how they should manage the fund.  An active fund manager will buy and sell shares with the hope that their decisions make a profit, which is in excess of the index.  The index is their benchmark or the league ranking they are measured against, to give a sporting analogy.

Each day the manager will arrive at their office and trade (buy and sell) shares in the fund, because they think (often based on some research or meetings) the shares that they sell are going down in price and the shares that they buy are increasing in price.  This is the activity, of active fund management.

Now let’s compare this to passive fund management.  Their remit may be, for example, to buy every share in the index, like buying each team in a league, and therefore rather than buying shares than rise and selling shares than fall, they buy both.

You may say that’s silly why do both? Well long term overall, share prices increase in value, historically this has been by c.9%pa, so the shares that rise often increase by more than this, and the shares that fall, fall by less than the risers, so the net effect or average is 9%.  They don’t return 9% every year, sometimes the risers win, sometime the losers win, but overall the winners win, they win by an average of 9%pa.

I appreciate that logically it makes sense to only buy the winners, but if you think about it, the fund manager doesn’t know for certain that they are winners, until they have won, then it’s too late.  It’s like being at the bookies, you may have a favourite, but the favourite doesn’t always win.  When you talk about the future, you’re giving an opinion, nothing is certain.

A picture can paint a thousand words, and below is a chart of the average active fund (in blue) and the UK stock market (in red) from January 1990 to November 2019.

active versus passive investing

Diversification

Some shares win and some loose, in fact, some loose so badly they go out of business and you lose your money.  This is why we buy funds rather than one or two individual shares; it spreads our risk.

So, how much does it spread your risk, investing into a fund?  If you are an active manager, typically your portfolio will have about 300 shares, therefore the fund manager, will need to know the ins and outs of all 300 companies, what they are doing, how they are trading and their challenges…a difficult job, if one or two go bust, you’ll feel it, not massively, but you would.

Whereas some passive funds, like the ones we operate at Lexo.co.uk have over 10,000 shares, so if a couple go bust…we’re less likely to be effected by it, and when you must own all the companies, it’s less essential knowing everything about them.

When investing, unless you have a crystal ball, diversification is your friend.

Charges

There’s a cost to investing, these costs are rarely explained in detail, but as a summary you have a manager’s fee, a custodian fee and trading fees, which includes the buy sell spread.

The managers fee pays for the management of the fund, the fund manager, the offices and marketing etc of the fund.  This is referred to as the Annual Management Fee (AMC)

The custodian’s fee is the price for your money to be held safely, in a custodian’s account, away from the fund manager.  You see, your money is not held in the fund managers account, encase they go bust, it’s held in a custodian’s account, so it’s safer and protected for you.

Finally, there are trading fees to include.  When you buy a share, there are several costs some of which are;

  • The difference, or spread, between the buying and selling price, which if you sold immediate would be a cost.
  • The stockbroker receives a brokerage fee for placing the trade.
  • HMRC receives stamp duty on every purchase.
  • There is also a cost referred to as slippage, which is where the agreed purchase price moves from the actual price paid hence the term slippage, this is also a factored costs.

If you are holding a share for a long time, you can loan the shares out to another fund, who has security and pays an income to you for the loan period they hold the shares.  Why they do this, is probably beyond this article, but they are hoping to make money on the shares if they fall in value!  Irrespective of their plans, you’re making money whilst you hold onto the shares, often whilst they are rising in value.

These are the charges, lets see how they effect the different managers; active managers are often paid substantially more than the passive managers, mainly because the passive managers are guardians and a computer programs makes decisions, so passive funds tend to have a lower management fee.

Custodian fees are generally similar for both active and passive funds, because this is a storage/safe keeping charge.

If you’re an active manager, your trading costs are substantially more, because you’re always buying and selling, hence active manager.  The turnover ratio (how much you sell of the fund and replace it) can sometime be over 100% in a year for an active fund, and less than 10% for a passive. Therefore, a passive fund has much lower trading costs.

If you’re always buying and selling and not holding on for long periods of time, you can’t really loan your shares and receive an income for this, but passive managers can, and this income effectively reduces the other fees charged.

It’s fairly typical for the total costs to be in excess of 2% for an active fund, and less than 0.5% for a passive fund.  Charges are a guaranteed (negative) drag on your investment returns each year.

Emotions of the manager

We’re all human and effected by our emotions, and market turmoil is a great example that effects our emotions, when the markets fall it can be worrying.  If you see your shares falling in value, selling them and holding cash seems a sensible decision, but when do you buy back in? It’s one thing to get out, but you can’t stay out, your job is to manage money, so when do you buy back in? When it’s recovered, so you have the cost of the trade, and you could end up buying back in at a higher price.

An argument against passive is that they follow the market down, it’s true they do, but to complete the sentence, they follow the market back up again too and without additional trading costs.

Summary

So in summary, with active fund management you are betting that the person managing the money has skill and insight to beat the collective market as a whole plus the additional cost incurred to achieve this.  Or you could accept that it’s virtually impossible to beat the market, why take the chance with your retirement money, and accept that a market return of c. 9% is acceptable.

The challenge is that you don’t know that you can beat the market, until you have given the manager a period of time to prove it, say five years.  So, you could look back and say over the last five years, you’ve done well, so you will in future?  However, Morningstar researched this and found that the top fund managers over one period, did not repeat their success over the following period, so novice investors were buying funds based on a track record, not knowing the probability the funds were about to go down!

 
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