Is active management still relevant?
The range of investment funds available to retail investors is vast and complex. Yet whatever the remit of the fund, there are only two fundamental approaches to managing assets that can be taken – active management or index tracking.
As debates go, this one’s always hot, hot, hot: comparing the investment philosophies of active and passive investment management.
What is active management?
Active investing is the process of constantly analysing and monitoring the markets and actively buying, holding, and selling at key moments to exploit fluctuating changes in prices. The goal of active management is to beat the performance of the overall market index.
To achieve this, active managers use a mixture of their instinct and experience, research, forecasts, and analysis to invest in what they deem to be the most attractive funds.
The benefits of an active approach include the freedom and flexibility to invest across the market (and avoid any sectors that go against a client’s requirements) and the chance to outperform the market.
As for cons, active investment is generally more expensive due to the higher fees involved. Plus many active managers take a longer-term approach, due to the resources required to carry out the in-depth analysis behind active decisions. As a result, the expenses can exceed potential market gains. There is also the risk that the performance of the fund is dependent on the talents and success of a particular manager and is not repeatable should that fund manager change.
What is passive management?
A passive approach, also known as indexing or tracking, aims to replicate market performance, rather than beat it. The goal is to equal the returns of a specific index by investing in securities that represent that index, as opposed to actively trying to anticipate and benefit from fluctuating changes in prices – there has been much research into the passive and active debate.
Back in 1991, Nobel Prize-winning economist William F Sharpe found that the average return on an actively managed dollar will be less than the average return on a passively managed dollar in his paper ‘The Arithmetic of Active Management’. This is because actively managed funds need to have a greater return to counteract the additional costs of active management.
So, by using a long-term investment philosophy, it aligns with the efficient market hypothesis, which states that market prices continuously incorporate and reflect all information, and individually picking stocks is therefore fruitless.
The benefits of passive management include considerably lower fees and expenses than an active approach and better returns. And more recent studies back this up. In July 2021, the FT Adviser reported that ‘just half of active managers performed better in monetary terms – after fees were taken into account – than their passive counterparts during the aftermath of the coronavirus-induced market crash,’ with just 21% of funds in the IA UK All Companies sector seeing better returns after fees than their passive equivalents. Not to mention, it is a quick and simple way to enter a market.
Examples of active managers that have beaten the market are often quoted, however research shows that this is seldom repeated consistently.
That’s why we’re proud advocates of passive management. To quote Abraham Okusanya, Chief Executive of Timeline, in an interview with Citywire, “We have looked at tonnes of research and evidence on retirement planning investments. We have read all the papers, and there is zero evidence that active investing or active management works better in retirement than passive.”
Want to know more about passive management? Check out our article on passive investors and corporate governance.