Ayesha Akbar: Should you go with the flow?

Active or passive investing? Each approach has its advantages

THE debate between active and passive investing has been raging for quite a few years now. Investors who favour passive investing believe that it is very difficult to outperform indices such as the FTSE 100, so they advocate simply buying low cost index funds, including exchange traded funds (ETFs) which simply buy everything in the index and therefore do not require any input from fund managers.

Those who support active investing, on the other hand, believe it is possible through good manager research and analysis to achieve better returns than the index.

The passive camp sometimes responds to this by arguing that even if it is possible to get higher returns than the index, the extra amount earned does not make up for the extra charges of active funds.

The active supporters' reply to this often involves pointing out well-known counter-examples of great active managers who have a proven long-term track record of consistently doing better than the index on a net-of-cost basis.

If we look a little deeper, however, we see that the debate between active and passive investing hinges to a large extent on whether one believes in the idea of 'market efficiency'.

In essence, if you believe that markets are completely efficient, then the prices of stocks are basically always correct. Now if is this was really the case, then there would be nothing to be gained from active investing, and passive investing would be always be the best approach.

Of course, the reality is that no one would seriously argue that stock prices are always perfectly correct. There can be many reasons for this. For example, we know that people don't always behave either rationally or predictably.

On the contrary, plenty of research shows that people can be subject to all kinds of psychological biases. Because of these ultimately human flaws, stock prices can also be incorrect at any point in time.

Providing additional backing for this, we also know of times in the past when stock prices were clearly and spectacularly incorrect - a particularly good example of this would be the internet bubble of the 1990s, which Alan Greenspan famously described as a period of 'irrational exuberance'.

However, while it is possible to be dismissive of the concept of efficient markets, it is actually more realistic and reasonable in my view to see the idea in relative terms.

In other words, while complete efficiency and correctness may not be possible, there may be certain situations where there is a greater or lesser tendency towards efficiency. The implication of this is that the debate between active and passive investing is not really and 'either/or' one. The value of each approach is likely to differ according the circumstances.For example, it is often argued that it can be harder for active managers to do well in those markets that are very well researched by the analyst community and therefore also more efficient.

Active managers might well respond that this is exactly the situation where outstanding research is required.

On the other hand, some research suggests that active managers can do a much better job than passive investing when there is a lot of market volatility. The idea here is that unlike in a passive approach, which will hold all of the stocks in the index, in these situations, active managers will have the flexibility to move in and out of sectors that they think are likely to do well or less well.

As with all investing, a very good general principle for investors is to first gain an understanding of how a particular product works. In the case of passive investing, it is important to know that things have moved on considerably from the old days when all the products available would simply hold all of the stocks in a particular index.

With the rise of ETFs, there is now scope for significantly greater complexity. This is because while some ETFs are similar to the simple index funds of old, others, known as 'swap-based' ETFs, are rather more complex because they do not invest directly in index stocks in the same way but instead make use of derivatives to achieve the same result.

So an increasingly important element of the debate between active and passive investing is for certain types of the latter to be more complicated and potentially more risky too.

Therefore the choice between active and passive investing should not be an 'either/or' decision. There will be some situations where an active approach is better, while other situations may tend to favour the passive approach.

The key as always is for investors to be very clear about what they want and to understand all the relevant risks before making any decision.

• Ayesha Akbar is Portfolio Manager, Investment Solutions Group, at Fidelity International