It’s a constant debate among investors – do you go for an active or passive approach?
Passive funds track a particular index such as the FTSE 100, in an attempt to mimic returns made by a whole market. Active funds on the other hand may only invest in a small handful of what they believe to be the very best stocks in a given sector in order to post returns in excess of the market as a whole.
In theory, when markets fall, actively managed investment funds have a better chance to post higher returns than passive rivals. This is because passive funds are forced to remain invested in poorly performing companies, while active managers have the flexibility to react to market events, dropping the bad performers and scooping up the market winners.
Last year should have seen a reversal of fortunes for actively managed funds, which have lost trillions of investor’s cash to cheaper index trackers in recent years.
But, with sharp falls in share prices, investors carried on pulling their money. Of the £11bn that savers withdrew from stock market funds in 2022, three quarters was pulled out of actively managed funds, according to the fund data provider Calastone.
It comes as just 27pc of active funds outperformed passive alternatives last year, according to the investment firm AJ Bell. Over the past ten years, just 39pc of active funds have delivered better returns than passive funds, it said.
Rob Morgan of the wealth manager Charles Stanley said: “There is increasing focus among both individual investors and institutions on cost in today’s economic climate. So, unsurprisingly, as more expensive active managers have underperformed, many investors voted with their feet.”
The average passive index tracker charges 0.11pc, while active funds typically charge investing fees from 0.7pc to around 1.5pc.
For many investors who hold active funds, 2022 may have been the final straw. But Rob Burgeman of RBC Brewin Dolphin said investors should remember there are almost no fund managers who will outperform in every economic environment.
Last year was abnormal in the severity of the downturn due to rising interest rates, soaring inflation and the impact of war in Ukraine, Mr Burgeman said. “This sea change meant that many falls were indiscriminate. In the UK last year, the oil and gas sector rose by 41.7pc, mining by 23pc, aerospace and defence by 21.8pc, tobacco by 21.7pc and pharmaceuticals by 12.1pc. Outside these sectors – which probably account for just 10pc of the FTSE 100 and a much smaller percentage of the FTSE All-Share – there were serious falls among active funds well below the returns of their benchmark indices.”
But passive funds too have their limitations. While trackers are well-diversified by nature, no one passive fund covers all asset classes.
“America’s S&P 500 index is heavily weighted to technology and e-commerce companies, whereas the UK’s FTSE 100 is more weighted to old economy areas such as financials, energy, and mining,” Mr Morgan said. “These stylistic biases can have a big impact on returns.”
Investors’ overall asset allocation matters more than choosing active or passive, Mr Morgan said.
While passive funds “are a sensible default option to populate portfolios, particularly in larger markets where it is difficult for an active manager to find an edge and add value”, active funds can capitalise in more niche areas such as smaller companies, where more proprietary research is needed, he added.
Mr Burgeman said: “The key is that the active funds that you use are properly active, and not just closet trackers at a higher cost.”
So-called closet tracker funds are marketed as active and charge higher fees, but in reality operate in a similar way to passive funds.
There are some sectors where active managers seem to have a far better chance of outperforming passive.
According to data from investment research firm Morningstar, 63pc of actively managed funds invested in large-cap US value companies sector beat their passive alternatives last year.
Mr Burgeman said the most important thing was to stay diversified: “Have some growth, but partner it with some income and some value-investing styles. In the US, a combination of a tracker and some active funds such as Baillie Gifford American and JP Morgan US Equity Income is likely to smooth some of your returns over the longer term.”