THE ACTIVE versus passive investing debate has been rumbling on for years within the investment industry and the media. Often the views are polarised – fully active or fully passive – but they also regularly miss out a key part of the debate: getting your asset allocation right. Myriad studies have highlighted that this is the key determinant of long-term returns, rather than choosing an active or passive stock picker.
While the debate rages on, investors are voting with their feet. In the US, the inflow into passive funds has been three times that into active funds in 2014, while in Europe the amount invested in exchange-traded funds (ETFs) has grown by an incredible 20 per cent this year.
The argument goes that the more money being managed passively, the easier it will be for active managers to find opportunities to outperform. We are clearly not there yet – in the US, where the adoption of passive funds is considerably higher than in Europe, 85 per cent of domestic equity managers have failed to beat the market over the past three years, according to Standard & Poor’s.
What the debate often fails to highlight is not only that active funds don’t consistently beat the market, but also the lack of predictability in choosing a good stock picker.
Economist Tim Harford likens fund-choosing to standing in line at the supermarket checkout – arguing that trying to find the fastest queue is futile, as there are too many variables. The shortest queue isn’t necessarily the fastest. In my view, you’ll only know whether you’ve picked a good fund after five years or longer – unlike the instant dissatisfaction of seeing another queue go much faster than yours.
But there is perhaps one reliable indicator of a potentially good or bad fund. A study by Morningstar highlighted that the best predictor of future fund performance is not the number of stars or awards it has, but the fees. Funds with high fees are likely to underperform and those with low fees are more likely to outperform.
That’s why I am a big fan of ETFs, the investment world’s equivalent of an “essentials” food range – good quality and value. They are very low cost, produce reliable performance and offer a very wide choice of investments. There are very few opportunities that cannot be accessed via an ETF, and in those cases a “closed-ended” fund (like an investment trust) would be a better alternative. A good example is physical commercial property.
One of the few certainties in investing is fees. They take a fixed percentage of your portfolio, regardless of market performance. Using ETFs, it’s possible to build global diversified portfolios that cost around 0.2 per cent a year. With active funds, the equivalent would be in the region of 1 to 1.5 per cent. Over time, the cost savings can be significant.
Whether you are firmly in the active camp or the passive, the sharp rise in passive investing can only be hailed as a good thing – healthy competition is lowering the costs for all investors alike.
Shaun Port is chief investment officer at Nutmeg. www.nutmeg.com