Active v passive fund management – investing in unchartered waters
So – 2020 – we can surely never have imagined our lives would change in the way they have in such a short space of time, and there is no indication that the pandemic is easing off any time soon.
When it comes to change, investment markets are not immune, with the majority of asset classes, even those normally uncorrelated to one another, facing uncertainty and greatly increased volatility. As such, most fund managers are in uncharted waters and investors have found themselves observing their investments closer than ever (and checking the lifeboats). To continue the analogy, to be in the right vessel in the first place, it is fundamental to understand your aims (including appetite for risk, timescales and capacity for loss), then you can consider how your investments are managed, as management styles and the structure of portfolios can differ significantly. You don’t want to be in a speed boat when an ocean-going tanker is more appropriate, and vice versa.
Fund management can be divided into two broad categories, ‘active’ and ‘passive’. So, what do these two things mean for your investments? Does one perform better than the other? Is one riskier than the other? Well, this depends on several factors including portfolio composition, fund manager decisions and market conditions, to name but a few.
A passively managed fund, as the name suggests, requires little to no management. This type of management style invests in stocks that make up a particular index, with the same weighting, thus aiming to replicate the specified index. Because of this, the returns on these funds are very close to the index.
In contrast, active management requires the fund managers to have in-depth knowledge of their market(s) and complete extensive research on the underlying stocks. This ‘hands-on’ approach allows talented fund managers to outperform passive funds, particularly when markets are volatile. Active managers invest in companies and sectors that they believe will generate the best returns, while avoiding those that they believe will generate poor returns. Because of this, they can/do achieve returns above or below the index. This type of management is proactive in its approach and better able to take advantage of opportunities (flex), which is particularly key in uncertain times.
Some actively managed funds take a step back from investing directly in assets – these are known as ‘fund of funds’. Rather than handpicking the underlying investments, the fund will incorporate multiple funds, which can give greater diversity to mitigate investment risk and so usually appeals to those who share their concerns about the economic climate. This may involve having exposure to gold or cash-based investments, as well as to themes such as healthcare, biotech and infrastructure.
Both active and passive managed funds tend to have defined strategies, giving investors the ability to adopt an approach that aligns with their preferences. Indeed, at this point, it is worth saying that combining the two approaches may indeed be the best of both worlds. This is because with certain assets, active management can struggle to outperform the (passive) index.
Remember, even when investing in a passive managed vehicle, you are making an active decision.
So, what type of fund management style should I choose?
Everyone will have their own thoughts on investment markets, but one thing I believe we can all agree on is the current unprecedented levels of volatility across the majority of asset classes. Studies have shown that people feel the impact of loss on their investments significantly more than gains, and I have found this to be true in my personal experience as an adviser, especially when the tide turns. Therefore, being in the right boat for what you want to achieve is best, as there are risks involved with changing just as the tides become rough. This further points to giving your portfolio manager a discretionary mandate, so they, as captain of your investment vehicle, can steer through the maelstrom, hopefully to calmer waters.
In volatile market conditions, it seems that an actively managed approach is a more favourable investment style, as investors seek reassurance and peace of mind. Investors benefit from the fund manager’s expertise and extensive market research, as well as their ability to make any changes needed with relative ease.
When it comes to cost, active management tends to be a little more compared to a passive option, given the increased level of expertise and market research required. However, as discussed earlier, active fund managers can underperform their passive counterparts, so it is important to identify those with the potential to outperform. This isn’t an easy task because there are thousands of funds for investors to filter through. Therefore, employing an investment manager to do this on your behalf can be extremely beneficial.
With the upcoming US presidential election, rising political tension (and potentially currency movements) from Brexit or the US/China trade war, it may make sense to have a hands-on approach where you can have the peace of mind that the radar is being regularly checked, with changes being made when needed on your behalf.
One thing for certain is that investment markets are never just plain sailing. Therefore, the real question is would you rather sit tight and weather the storm, or would you rather have the peace of mind of being navigated through whatever that storm may bring?
Nathan Smith, consultant at Mattioli Woods