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Active or passive — both approaches have their benefits

DATE: Feb, 2   COMMENTS: 0   AUTHOR: Allan Azarola

Should you pick a fund manager with an impressive record, or go for a tracker with competitive fees?

You want to invest your Isa allowance in the stock market, but deciding what sort of investment approach you should take is not straightforward. Is it worth trying to second-guess the market in order to beat returns elsewhere, or just follow the herd and hope it takes an upward curve?

Actively-managed funds are more expensive than so-called index-trackers because they are managed by expert fund managers who research and select the stocks they believe are going to perform the best. Passive funds, on the other hand, just replicate the contents of a given index of shares and switch holdings in line with that. These tracker funds are generally cheaper as they do not require the input of a highly-paid manager.

Patrick Connolly, a certified financial planner at Chase de Vere, said: “The typical annual charge on a tracker fund is often about 0.2% a year or less. This compares with the typical annual charge on an active fund, which might be 0.75% a year.”

Our table shows the cheapest UK trackers that accept investments of £1,000 or less, according to data from investment research firm Morningstar. For instance, it shows that investors can gain exposure to the companies in the FTSE All-Share index for as little as 0.06% of their holdings a year, using the Fidelity Index UK fund.

The odd percentage point here and there may seem like a small amount. However, it can hit you hard in the wallet when investing for the long term. For example, slashing a single percentage point from annual fees could bring a 35-year-old investor nearly two extra decades of retirement income, according to investment manager Netwealth.

Netwealth took the example of a 35-year-old who has built up a pension pot of £12,000, and then continues to invest £250 a month until the age of 65. With returns of 3.5% a year after charges, it could then generate an income of £9,000 a year for 24 years. However, cut charges by a percentage point, so the returns bump up to 4.5% a year, and the income could continue for 43 years.

One big risk with passive funds, however, is that they blindly follow their indices. Some of the experts described tracker funds as “the ultimate lemming investment”. If the market rises, so will your money — but it can also fall off a cliff. In contrast, active fund managers can pick and choose where to invest, seeking to identify the most attractive opportunities, avoid unattractive ones and take defensive action in difficult times.

For example, active funds can take advantage of the “irrationality of investor behaviour”, said Tom Stevenson, a director at investment provider Fidelity International.

“There are opportunities for active investors to exploit irrational peaks of optimism and pessimism to buy shares when they are undervalued and sell them when they become overpriced.

“The history of stock market booms and busts, from the Wall Street crash to the dot.com bubble and the more recent financial crisis, suggests that share prices do indeed tend to overshoot in both directions.”

Are active funds worth it?
The issue is that very few active funds actually deliver better performance than the market, year in, year out. In fact, the vast majority of actively-managed funds failed to beat their benchmark over periods as long as 10 years, according to research by index provider S&P Dow Jones Indices.

Alexis Gray, investment strategist at fund manager Vanguard, said: “It is difficult to consistently outperform the market. When you pay a high fee to a manager, they have to earn it back for you – which sets a high hurdle, because the fund needs to not just beat the market but also pay back the fee.

“You do get the occasional star fund manager with the ability to outperform the market. However, in some other cases, managers charge the fees but don’t deliver the performance, so can under-perform their passive benchmark.”

Connolly was also concerned about whether active funds always deliver value for money. He said: “Passive investment funds are becoming increasingly popular — and with good reason, as many actively managed funds charge too much and deliver too little.”

In practice, the investment experts all recommended combining both active and passive funds to build a diverse portfolio. Stevenson suggested using “a core of passive funds, to provide cheap market access, with a group of satellite active funds to add the potential for outperformance”.

Whatever combination of funds you choose, it is still worth checking the fees. According to Morningstar research — part of its Guide to Passive Investing report — lower fees are the best predictor of future returns, the rating agency said.

Gray explained: “The average return on a low-cost fund tends to be higher than on a high-cost fund, once the fees are stripped out.”

Crucially, do not assume that all passive funds are cheap. The Virgin FTSE All-Share Tracker fund, for example, charges 1% a year — 17 times more expensive than the cheapest UK tracker in our table — and yet still has almost £2.7bn invested in it.

You can find the ongoing charges listed on the Key Investor Information Document (KIID) for any individual fund.

Active managers bite back
In funds, as in football, it is rare to find managers who deliver a winning record year after year.

Yet there are still talented fund managers who, much like Sir Alex Ferguson before his retirement, have consistently beaten their benchmark over the longer term.

Pick the right active fund, and the extra growth can more than compensate for extra fees. Past performance is no guarantee of future returns, but it can be a useful starting point when choosing investments.

Jason Hollands, managing director at wealth manager Tilney Group, suggested that investors should consider the results achieved by managers throughout their career.

The Tilney Group analysed almost 500 equity managers with more than five years of returns. The study identified Neil Woodford, previously with Invesco Perpetual and now head of his own firm, Woodford Investment Management; Martin Cholwill who manages the Royal London UK Equity Income fund; and Anthony Cross and Julian Fosh, who work together at Liontrust, as the top-performing equity fund managers over the course of their careers.

TD Direct Investing recently revealed the latest results of its Best of British research, highlighting UK active fund managers who have beaten the market over the past 10 years. Mark Slater, at MFM Slater Growth, led the field, followed by Nick Train at CF Lindsell Train UK Equity, and another appearance by Anthony Cross from Liontrust.

Investment trusts, which are all actively managed, have performed better than their benchmarks more frequently than open-ended funds, such as unit trusts over the medium and long term, according to Annabel Brodie-Smith of the Association of Investment Companies.

Several managers with strong performance have long histories, including Peter Spiller, in his 35th year managing Capital Gearing, Sarah Whitley who has headed up Baillie Gifford Japan for 26 years, and Job Curtis, who has delivered rising dividends at City of London Investment Trust for 26 years.

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