Active management or Passive management? A discussion that has been ongoing for decades. Since 1970 Passive Management has been an academic concept (initially introduced by Jack Bogle), but this concept did not truly gain traction until the 90s due to the popularity of Vanguard’s low-cost indexed fund products. [2] More and more individuals are being drawn to passive management. [3] Why is this? Is there any evidence that supports this outlook? This article will answer those questions and focus on the core principles behind each strategy, whilst giving a prediction on what is next.

The Core Principles

Active management is when the portfolio manager (PM) actively looks for growth and profit opportunities, with the sole aim of outperforming a benchmark, for example, an index. The discovery of these opportunities stems from a portfolio managers’ ability to identify mispriced securities with potential high performance. Within active management, the PM also has the ability to protect against downside, due to an underperforming security, by hedging the risk. This could be done through decreasing the weighting of an underperforming stock in that fund. Downside (risk) is simply an estimation of how much a security will decline in value if market conditions change [2]. Hedging is actions taken by a person to protect themselves against risk.

Passive management is when a PM creates a fund that tracks an index. These are called tracker funds. A popular example of this is Exchange Traded Funds (ETFs). The stock weightings within this fund and the index will be identical. The nature of passive management means that the fund will always follow the performance of the index it is tracking, including in periods of economic downturn. The underlying theory behind passive management is the one of Efficient Market Hypothesis [2]. This is an investment theory stating that stocks always trade at their fair value on stock exchanges (when all information has been considered).

The Arguments

For a long time active fund management was widely regarded as the best way to manage a portfolio. However, since the introduction of passive management, there have been doubts over whether active management indeed yields better results than passive management. I will talk about this in further detail.

The benefits of active management are as follows:

  • Provides the potential to outperform an index (and therefore the market)
  • The PM has the ability to protect against downside risk
  • There is an ability to make profits in times of economic downturn
  • PMs are able to create a portfolio that matches their client’s risk profile, therefore providing a better service

The ability of an actively managed fund to outperform its underlying index is the element that gives it an edge over passive management. However, this factor can also be seen as its biggest downfall. Successfully outperforming an index requires intense analytical research and, potentially, the frequent buying and selling of stocks to capture upside in the market. To be able to provide this hands-on service, active fund managers have to charge higher fees but, the fund is not guaranteed to outperform its underlying index. The fund could underperform. Hence the problem; many investors are unwilling to pay such high fees without this guarantee, leading them to invest in tracker funds because they would argue that the same results can be achieved for a lower cost. On average, within equity fund management (shares), there are base fees of 80-90 basis points (i.e. 0.8-0.9%) per year with performance fees around 7.5-10% [5].

The benefits of passive management are as follows:

  • Low cost due to much lower fees (on average, passive funds charge base fees of 0.15% per year [6])
  • Passive funds will very closely follow the performance of the fund that they are tracking without any deviation due to no interference from a PM

The low cost, and mostly still high performance, element of passive management attracts people towards this method of investing. The problem with this is, the tracker fund will only perform well in periods of economic upturn. In periods of economic turmoil, tracker funds (and passive management in general) will not perform well because companies will be struggling and share prices will be falling. The value of the fund will fall along with these share prices. Essentially, tracker funds can never outperform their underlying index due to fees. Passive investors only have to pay the cost of market participation [5], as within passive management it is harder to cater to the risk profile of individuals.

The Evidence

60% of large-cap active funds beat their benchmarks over the first 4 months of 2018. A large-cap fund is a fund that invests in companies with large market capitalisation. The average active fund outperformed its underlying index by 0.18%. However, only 37% of small-cap active funds beat their benchmark over the same period. Why is this? Mid-cap and small-cap indices were down 12.84% and 15.66%, as of June 2018, respectively.

My Prediction

Early this month, Fidelity introduced two zero fee index funds. Although they will be taking a loss on these funds, they aim to bring in assets and make revenue by selling other services, e.g. financial advice [1]. This has increased competition amongst investment management companies to gain assets; a price war seems likely. I believe that as these companies seek to undercut each other, aggregate fees will get lower and therefore attract more investors to passive management.

However, as discussed above, we know that active funds have the ability to make profits in times of economic downturn. We are currently in a time of economic turmoil due to: Brexit, geo-political issues (e.g. the trade war between US and China) and other factors. If, as seems likely, we were to end up with a no deal Brexit, this will be closely followed by a period of economic downturn. I believe that during this period, active fund managers will utilise their ability to protect against downside risk, which will in turn lead to increased returns and increased performance of active funds. Could this lead to a rise in popularity of active funds? Very possibly.

[1] Bloomberg [2] Investopedia [3] Morgan Stanley [4] thebalance [5] The Financial Times [6] The Telegraph

You’ve successfully subscribed to Finance Focused
Welcome back! You’ve successfully signed in.
Great! You’ve successfully signed up.
Your link has expired
Success! Check your email for magic link to sign-in.