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Active vs Passive Fund Management

There are two styles of investment management; active fund management and passive fund management. The proponents of both make exhaustive and valid arguments in favour of their approach.

In a nutshell, the difference between the two approaches is an actively managed fund will be overseen by a fund manager or team who attempt to outperform a specific benchmark such as the FTSE All Share Index; a passive fund will simply attempt to replicate the return of that benchmark using one of a number of computer modeling techniques.

Proponents of active fund management believe that investment markets are inefficient and that fund managers will be able to take advantage of these inefficiencies. Active fund managers will therefore alter the investments held in their portfolios to take advantage of mispricing opportunities they identify and through this will attempt to beat the chosen benchmark.

Passive fund managers argue that markets are fairly efficient and that the best way to capture the returns is to buy and hold all (or most) of the assets that make up the benchmark or index.

We have reviewed both sets of arguments and consider the following points to be important.

As a basic premise we have used simple laws of arithmetic which dictate that the average investor will achieve the market return. This is because one Investor's gain is always going to be another Investor's loss and one will offset the other. Every fund manager cannot therefore be a winner. For active fund management to provide better returns than passive fund management, we must identify fund managers who are going to be able to beat the benchmark on a consistent basis.

In order to beat a benchmark, active fund managers will need to make the right calls on which assets or sectors to invest in and get the timing right – the 'buy low sell high' maxim. Attempting to do this increases risk and is difficult to get right on a consistent basis. Empirical evidence shows that the majority of active fund managers have not beaten their benchmark on a consistent basis.

One of the best guides (and often the most commonly used) to selecting active funds is to look at the past performance of the fund or manager, but this is not necessarily going to be indicative of future performance. Using active funds therefore adds an element of 'gambling' to investment decisions in the sense that we would be trying to predict tomorrow's winners.

The charges on actively managed funds tend to be higher than on passive funds. Aside from the cost of the fund manager and research staff, there are other costs which must be considered. For example, active funds tend to have higher trading costs compared to passive funds as they move in and out of securities in an attempt to add value. The cost and tax implications of turning over securities can be significant, particularly in the case of securities traded outside of developed markets and are not required to be disclosed in the fund literature. These 'hidden' charges can be a significant drain on returns.

Successful actively managed funds can become a victim of their own success in that the larger the fund becomes, the more difficult it is for the fund manager to react quickly to take advantage of investment opportunities.

On the basis of the above, we believe that the majority of investment portfolios should be constructed using passive funds where possible. This will remove from the process the need for luck in selecting the correct fund manager and provide access to market returns over the long term at considerably lower cost. We offer a range of passive solutions which can be tailored to your needs and circumstances, along with other solutions for those few situations where other investment solutions may be appropriate.

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Financial Planning Partners (FPP)
19 Wellington Business Park
Dukes Ride
RG45 6LS

Email: admin@fpp-ifa.co.uk
Tel: 01344 778990

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