Active vs Passive?

The 3rd part of the choosing your financial adviser series.

When deciding to work with a financial adviser, one of the key topics to cover is what their preferred investment strategy looks like, do they believe in efficient markets and therefore lean toward passive investing or are they of the opinion that there is money left on the table and additional Alpha can be obtained by being more active with their investment selections.

This article aims to help breakdown the differences, the upsides and the downsides to each but at the end of the day, a good adviser will listen to the needs and objectives of his client and provide the advice accordingly.

The debate over the merits and shortcomings of active versus passive investment management has been ongoing for several decades. At its core, this debate revolves around the ability (or lack thereof) of active managers to outperform their benchmarks and whether investors should abandon active strategies in favour of passive investments. This is a crucial consideration for any investor developing an investment strategy.

Performance Analysis

Over the past two years, there has been a noticeable shift in investment flows from active to passive funds. This trend highlights a growing preference among investors for passive investment strategies, primarily due to their lower costs and perceived reliability in delivering market-average returns.

2022:

• Active Funds: Experienced significant outflows, with investors withdrawing substantial amounts of capital. The trend was particularly evident in equity funds, which saw net outflows throughout the year.
• Passive Funds: In contrast, passive mutual funds and ETFs continued to attract capital. For instance, in 2022, passive funds saw substantial inflows, particularly into equity ETFs and index funds, reflecting a growing investor preference for these low-cost investment vehicles.

2023:

• Active Funds: Continued to suffer net outflows. Over the trailing 12-month period ending in September 2023, active funds reported outflows of approximately $606 billion. This trend was consistent across various categories, with significant outflows in U.S. equity and taxable bond categories.
• Passive Funds: Maintained their momentum with net inflows. During the same period, passive mutual funds and ETFs recorded inflows totalling around $468 billion. The disparity between active and passive fund flows was particularly pronounced in the equity segment, where passive funds saw consistent inflows.

The shift from active to passive investments underscores a broader trend in the investment landscape, where investors are increasingly favouring the predictability and cost-efficiency of passive strategies over the potential but uncertain outperformance promised by active management. This trend is expected to continue as more investors seek to minimise costs and achieve reliable returns in a volatile market environment

Pros and Cons of Active Management

Pros:

• Opportunity to outperform the market: This is the primary goal of an active manager.
• Flexibility: Active funds can invest more freely than their passive counterparts, as they are not bound to an index. This allows for accommodating specific ethical or other client requirements.
• Risk management: Active managers can mitigate potential losses by avoiding certain sectors or regions.

Cons:

• Performance depends on the manager's skill: There is a risk that an actively managed fund may underperform.
• Higher costs: Active management requires higher fees to cover the expertise and resources involved. There is significant pressure on active managers to deliver results that justify these higher fees. Some managers have become 'closet trackers' to avoid major performance errors, while others deviate significantly from their benchmark to achieve outperformance, which can increase risk.
• Hidden fees: Many active funds have additional charges of upto 5% on entry or 5% upon sale of a fund, these hidden fees can often be used to remunerate advisers who choose to place client money in the fund, it could be argued that this is a form of commission bias.
• Lack of diversification: Typically, active funds have a team of Chartered Financial Analysts (CFAs) who will examine a smaller segment of the overall market which can impede diversification.
• Key man risk: If the manager of an actively managed fund is unable to continue, the successor may not be as talented, unlike in passive funds where the process remains unchanged regardless of personnel.

Pros and Cons of Passive Management

Pros:

• Predictability: A passive fund is unlikely to significantly underperform the market index.
• Low cost: Management fees are generally lower than those for actively managed funds. Academic studies highlight that low fees and expenses contribute significantly to passive funds' outperformance.
• Accessibility: Passive funds provide a straightforward way to gain market exposure.
• No key man risk: The fund’s performance is not reliant on a specific manager.

Cons:

• Lack of flexibility: Passive funds follow a predefined index and cannot adapt quickly to changing market conditions.
• No chance of outperformance: Passive investors aim to match the market return, not exceed it.
• Limited choice: Investors must accept an index as it is, regardless of the quality of its underlying holdings. Most indices are based on market capitalisation, which can lead to a focus on larger companies or sectors currently in vogue.

The Role of the Adviser

As this article highlights, the decision on which approach is ‘best’ is not as simple as one might expect, especially given the historical evidence for and against, and in turn the pros and cons, of each approach.

The role of a good financial adviser is to ensure the portfolio meets your requirements, both from a return and risk perspective. A financial adviser who listens to his clients, identifies their short, medium and long term objectives and takes note of what matters, whether that is cost sensitivity, performance driven metrics or a fear of loss is what can make the difference between good, bad or ugly advice.

Do you have any unanswered questions?

Feel free to reach out to me via LinkedIn or email me on lewis.sell@sjb-global.com. I would be more than happy to offer some additional information upon request, or to help you explore your specific options.

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