If you can't beat 'em, why not try the passive approach?

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WHEN a leading investment fund manager, handsomely paid for his stock-picking skills, suddenly declares that he has always believed in passive investing, private investors have good reason to sit up and take notice.

The raison d'etre of the fund management industry has been that, over time, an actively managed fund – that is, one where the manager picks and chooses shares – would outperform a fund passively invested in an index such as the FTSE100.

Passive investment by contrast condemned the investor to no better than an index performance. And, because index or "tracker" funds remain fully invested, participants are trapped in downswings, with no discretion to adjust fund weighting in the light of changing markets.

So imagine the consternation when Alan Miller, the former chief investment officer of fund management group New Star, recently declared that he had always believed in passive investing.

Miller was paid 3.3 million in 2003 as chief investment officer and manager of New Star's Hedge Fund. Thus for New Star's investment clients it was quite an eye-opening declaration when he let it be known that he has been investing his money in Exchange Traded Funds and index trackers for years while – as Alan Dick, head of Glasgow-based independent financial adviser FortyTwo Financial Planning, bluntly put it to me last week – "earning massive fees and bonuses for under-performing the market with other people's money".

Alan Dick has long been a supporter of the passive investment approach. It's simple to grasp, requires little management, and is, in terms of staff and running costs, cheap as chips.

Miller's confession cannot but rekindle debate across the personal finance industry on the "active v passive" issue and whether active management "pays".

"The vast majority of IFAs and stockbrokers," says Dick, "are still wedded to the belief that talented fund managers can beat the market through stock selection. Most fund managers and stockbrokers earn substantial fees for trying to beat the market despite the fact that almost every academic study shows it is a futile quest."

He adds that several fund managers and ex-fund managers often confess to him that, although their job is to try to beat the market by gambling with other people's money, "they invest all of their own money in passive funds… It is difficult to get these people to own up in public as their careers depend on taking high fees for trying to do the impossible."

After the vicious bear market of the past 18 months it is not hard to see how this critique plays to a great body of investor disillusion over actively managed funds. Almost all funds have suffered badly, the few honourable exceptions being those such as Personal Assets Trust, which were substantially liquid as the storm broke. Investors in passive funds had no option but to brave the storm and wait for it to pass.

But most active managed funds fared little better. They suffered with the rest, though on the way down investors had the further indignity of having to pay annual management charges for a typical 30 per cent drop in the fall of their investments.

Many still cling to the belief that there is a minority of fund managers such as Anthony Bolton (Fidelity) and Neil Woodford (Invesco Perpetual) who can deliver long-term out-performance that justifies the expense and the short-term volatility of returns. But the dynamics of markets change over time, and this can leave yesterday's star performers high and dry.

Game, set and match to the index trackers? Not quite. One of the reasons for the continued dominance of actively managed funds is that they are often the only way investors can gain exposure to specialist markets or sectors. This is particularly the case with emerging market funds and those funds specialising in venture capital and natural resources. A suitable tracker fund option is just not to hand.

However, the passive investment school does have a strong point when it comes to investment in mainstream UK or US equities – with one caveat. Passive funds will not go liquid or avoid vulnerable sectors on your behalf. When the banks went down, they took all passive investors with them.

Investors need to be aware of this and to bear in mind that it is they who have to make the call as to how much they wish to be exposed. This is a big weakness of the passive investment school. On the plus side, however, are those sharply lower investment fees and charges which can make a big difference to investment performance over time.