Investments - despite what your financial adviser may say, passive is not so bad

Published on Friday 12 September 2008 19:14

WHETHER to go active or passive may sound like a philosophical question, but it's one of the investment industry's longest-standing debates.

Those who use nothing but tracker funds and, more recently, exchange traded funds (ETFs), including some wealth management companies, argue that it is the best way to get the most accurate exposure to a particular asset class with the lowest charges.

Alternatively, financial advisers and planners dismiss tracker funds altogether, arguing that actively managed funds should be able to outperform. Some also claim that tracker funds only really work in a rising market, although this argument does not stand up when considering the performance of most active funds during bear markets.

An issue that impacts on the impartiality of the financial adviser world is that most companies rely on generating commission in order to get paid and actively managed funds tend to pay commission, whereas tracker funds and ETFs usually do not.

This implies that financial advisers may have a vested interest in recommending managed funds, regardless of what is best for their clients.

While commission is undoubtedly a key reason tracker funds are not more widely recommended, another important reason is ego. It is often difficult for portfolio managers to acknowledge that they cannot pick funds that will consistently outperform the relevant benchmark or index, when their expertise is supposedly in picking funds and building portfolios. After all, investment managers need to justify their existence.

The reality, however, is that tracker funds should have a place in an investment portfolio where you are not confident that an actively managed approach will consistently outperform the benchmark.

For example, it is extremely difficult to find equity funds that will consistently outperform the more efficient markets, such as UK and US large-cap indices.

However, other markets such as Europe, Japan or UK and US small-caps are not considered efficient and there are stock opportunities that a good quality fund manager may be able to exploit in order to provide stronger performance. In these markets the case is more in favour of active funds.

The UK equity market is an interesting example. When the FTSE 100 index is not performing as well as mid-cap or smaller companies, then there is more chance that active UK funds will outperform the FTSE 100, as many funds will have exposure to mid and small-cap companies. Therefore little attention will be paid to trackers. However, when large-cap stocks outperform, many investors will see their funds under-performing the FTSE 100. They may then decide active management is not worth paying for and that a tracker is more appropriate.

However, using a tracker fund to get full UK equity exposure may not be the best approach because the mid and small-cap arenas are not so efficient.

In the UK, therefore, the solution may be to consider a tracker for large-cap stocks but take an active approach for mid and small-caps.

There are other areas where trackers and ETFs should be considered. For example, if investing into a gilt fund, the amount of excess return an active manager can add may be marginal and so not make up the extra costs of paying active management charges.

The optimum solution, therefore, is to invest in a range of both active and passive investments.

&#149 Graeme Lind is a wealth adviser at Towry Law in Edinburgh