Should you only invest in cheap tracker funds?

by Jonathan Adams
Passive funds

Passive funds that are built to replicate the performance of a particular stock market index, like the FTSE 100, S&P or MSCI Global Environment Index, have seen a huge surge in popularity in recent years. Investment Association (the fund industry trade body) data shows that while only 13% of the cash put into funds by retail investors between 2008 and 2013 went into passive funds, that has since risen to nearly half.

There are two main reasons for the mass migration of retail investors into passive, or tracker funds as they are often known. The first is that the long equities bull market that’s been in place since 2009, only briefly interrupted by the major sell-off last March as the Covid-19 pandemic struck, has meant major global benchmark indices have consistently delivered attractive returns.

The second reason for the recent surge in the popularity of tracker funds is related. The strong performance of benchmark indices has made it difficult for actively managed funds to achieve better results. Especially when higher fees are factored in.

That’s seen a significant majority of actively managed funds underperform their benchmark over the past decade – a reality that has been widely covered in the media and often used as a broom with which to beat the actively managed sector.

Unsurprisingly, it also discouraged investment into actively managed funds with retail investor capital flows instead diverted into passive trackers.

But last year’s market turbulence and stock market crash early in the year finally created the kind of conditions in which actively managed funds can excel. And while there were exceptions there were also many notable success stories of outstanding returns being generated by active fund managers.

Suddenly, the accepted wisdom that there is little incentive for small investors to pay returns-eroding fees for active management has been called into question again. Perhaps only investing in cheap passive tracker funds isn’t necessarily a fool-proof solution after all?

Let’s consider the arguments why there is still a place for actively managed funds in a balanced, long-term investment portfolio.

Passive funds

As already mentioned, passive funds are designed to mimic, or ‘track’ the performance of a particular index. To do that they buy the instruments the index tracks. For example, a FTSE 100 tracker buys shares of all the companies that are components of the index. And of course, they also have to be bought to the same weighting they have in the index.

Because buying components of an index in a way that reflects their weighting in the index can all be managed by computer algorithms, there is almost no need for any human involvement at all. Which is why passive funds are cheap. Fidelity index trackers are currently the cheapest on the market in the UK and can cost as little as 0.06% per annum, or £6 for every £10,000 invested.

Passive funds also don’t just track the benchmark and other main indices of stock markets, like the FTSE 100, FTSE 250 or FTSE All-share. There is now a wide selection of indices compiled by different companies like FTSE, S&P and MSCI tracking all sorts of sectors and other ways to group stocks and other financial instruments like commodities and bonds.

There are ESG indices, national and global, healthcare indices made up of companies in the health sector, mining and commodities indices, technology indices, cloud computing indices and even indices tracking the performance of publicly listed legal cannabis companies. There is an index, and probably a passive fund tracking that index, for almost any category of investment or sector you can think of.

“Smart beta” passive funds are a new category. They are programmed to buy stocks that match pre-set criteria, like the size or growth of dividend payments, revenue growth levels etc. The fund will automatically sell assets if they no longer match the fund’s criteria and buy those that newly do. It is likely that investors will soon be able to customise their own ‘smart’ passive fund criteria.

Most passive funds are either index-tracking funds or ETFs. Both formats can be bought and sold via a stockbroking account. The main difference is that index funds are bought and sold at a price set at the end of the trading day and valid until reset the next day while ETFs can be bought and sold like stocks throughout the day.

The strength of passive funds is their low fees, though be careful as some more exotic ETFs for niche sectors can charge more expensive fees and the fact they nullify the risk of an investment underperforming the market.

The downside to passive funds is they will never outperform their underlying market so returns reflect, for good or bad, the general stock market or sector performance. There is no way to either benefit from temporary market trends or adapt to changing conditions.

That essentially means passive funds do well during bull markets and poorly when things turn bearish. The bet is the long-term trend of the market or sector being tracked is a positive one. If it is, human interference won’t either compromise gains by making a few bad investment choices or erode them through fees.

Active funds

Active funds come in a number of formats with the most common being unit trusts and mutual funds. There are also actively managed ETFs.

The fundamental difference between active and passive funds is that a fund manager, backed up by a research team, chooses the financial instruments like stocks, bonds and commodities, the fund invests in and their weightings.

An actively managed UK large-cap fund won’t invest in every company in the FTSE 100 at the same weighting it has in the index. The fund manager will only invest in the FTSE 100 companies whose valuations they expect to increase over the next few years. And they will invest with a weighting they feel reflects the strength of the company’s prospects, taking into consideration risk factors that could derail progress.

Fund managers must understand how a company works, its growth prospects, broader market trends, competitors landscape, have an opinion on the quality of the management and so on. Timing when the fund buys in and sells out of an investment is also crucial.

Investors in an active fund rely on the fund manager and research team’s expertise to adjust the fund’s portfolio as the prospects of the companies or other financial instruments it is invested in evolve, taking into consideration wider economic and market conditions.

One major plus many investors see in active funds is that, depending on their investment strategy, they have the power to influence the companies they invest in. As major shareholders, fund managers can engage with and put pressure on companies to improve their ESG metrics – their environmental, social and governance standards and policies.

Actively managed funds cover a broad range of approaches and industries. Equities funds only invest in stocks and shares, and there are also general funds that also allocate some of their portfolio to bonds and commodities. Equities funds might be growth funds, meaning they invest in companies expected to show high growth in coming years. Or they might be income funds, that invest in companies that pay higher dividends.

Active funds can also target a particular geography, like North America, Asia, or emerging markets. Or a particular industry or sector, like technology, biotech, energy or infrastructure. Or they might only invest in larger companies or smaller companies.

While a majority of fund managers notoriously fail to consistently beat their benchmark index, especially in recent years when it has been admittedly difficult due to a powerful bull market, some consistently do. The returns the best active funds deliver can make typical annual management charges of 0.75% to as high as over 2% worthwhile. The problem is, those charges rub salt into the wounds when an active fund underperforms.

The case for including both passive and active funds in a diversified investment portfolio

Passive funds are a great backbone to any general-purpose, long-term investment portfolio and will usually account for the majority of capital invested. They are, in the historical context of major stock markets and indices growing in value over the long term despite temporary volatility, low risk, cheap and offer built-in diversification. A selection of passive funds offers exposure to thousands of underlying investments across industries and geographies.

But while passive funds are the building blocks of a diversified, balanced portfolio, active funds can also play an important role. Investors who value an ethical approach to investing might want to put more of their money into active funds as investing in index trackers unless they track an ESG index, inevitably means putting money into companies without any discretion to their behaviour and policies.

Investors who want tailored exposure to a particular geography or sector they believe has a bright future might also consider an active fund, especially if no passive fund offers suitable investment exposure. Or for higher risk investments, like in start-ups, that require the specific expertise of an experienced fund manager.

Ultimately it will come down to a particular investor’s priorities and considerations. The average long-term investment portfolio might be expected to have a roughly 70-30 or 80-20 split between passive and active funds. Passive funds providing the foundation of the portfolio and active funds pursuing higher returns based on the investor’s interests, beliefs, and opinions.

This article is for information purposes only.
Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.
There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

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