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Active or passive? You’re asking the wrong question!

The merits of active funds over passives generate lots of column inches, but there are more important investment decisions to make.

 

by Mike Deverell on Nov 19, 2015 at 08:00

Active or passive? You’re asking the wrong question!

'Should I invest in active or passive funds?'

This is a question that generates plenty of column inches, but frankly I think it’s the wrong question to be asking! Or at least, when constructing a portfolio it is way down the list of things to consider.

There are a number of steps to go through first before you get to the question of what to buy:

  • What am I trying to achieve? What’s my money for and when do I need it?
  • What return do I need in order to achieve my goals?
  • How much risk do I need to take to get there?
  • How much risk am I willing to take?
  • How much can I afford to lose?

Some of your answers might conflict with others. In order to achieve your desired outcome you might need to take more risk than you are willing or can afford to take. That might require compromise.

This is essentially a financial planning exercise. Only once you know the answer to those questions can you then move onto the actual investment and select an asset allocation which best meets your needs.

Deciding your asset allocation is the most important investment decision you will make. How much money you invest in equities, for example, makes much more of a difference compared to which fund or which stocks you buy. How this is balanced by cash, bonds, property or alternatives to provide diversification is vital.

Having made that decision, you might think now is the time to decide whether to go active or passive. Not so fast!

Fund behaviour

An important but underrated step is to consider what fund style or behaviour you require. Funds are the building blocks of your portfolio and what matters most is how well each one fits in with your overall plan.

The most obvious part of this exercise is deciding whether the fund needs to invest primarily for growth or income, but it is more than that. For example, if we are looking at UK equities do you want a fund that is more defensive and will fall less when the market drops, or more aggressive and more likely to outperform when it goes up?

You need to consider how well each fund complements other holdings in your portfolio. There’s little point having two funds doing the same thing. You want funds which will perform well at different times.

What drives fund performance?

There are a number of known factors which might explain why a fund does well or badly.

Nobel laureate Eugene Fama and Kenneth French showed that, over the long term, small caps tend to beat large caps whilst value stocks also tend to outperform. Fama and French defined value stocks as those with low price-to-book ratios; a low market value relative to the value of net assets shown in the company accounts.

You can enhance your chance of long term outperformance by tilting your portfolio towards small and value stocks. These are generally riskier than the market. Smaller companies have a greater chance of failure than large ones and value stocks are usually cheap for a reason, such as perceived poor prospects. A small cap or value fund will not necessarily be more volatile than the market but this doesn’t mean those risks are not real.

Other scholars have mooted a fourth factor; momentum. Stocks tend to overshoot fair value both on the way up or the way down. This is where the 'run your winners' argument comes from.

So if those factors can help performance, what can hurt it? The principle one is cost, whether that is management fees or trading costs. A fund with a high turnover will have high trading costs which won’t show up in the fund’s ongoing charges figure (OCF), only in performance.

Finally, only a fund with a reasonably high 'active share' will have a chance of beating an index. A fund with an active share of 15% is essentially 85% the same as the index. Any outperformance will probably be swallowed by charges.

In summary, a good fund needs a strong process and usually at least two of the following style factors:

  • a tilt towards smaller companies;
  • a disciplined, value approach or
  • a 'run your winners' approach;
  • low management fees;
  • low turnover;
  • a high active share.

Some examples

Two of our favoured UK funds are the Miton UK Value Opportunities and the Lindsell Train UK Equity fund. These are very different:

  • Miton buys 'undervalued' assets and sell them when they hit a target price.
  • The Miton fund invests a substantial proportion in smaller companies.
  • Lindsell Train holds strong, high quality companies and runs its winners.
  • The turnover of stocks within the Lindsell Train fund is very low.
  • Both funds have a high active share.

These funds tend to perform at different times making them a good potential combination. They are both tilted towards a number of the known factors which influence performance. Whether or not their strong past performance is down to manager skill or simply because of these style factors is irrelevant. They provided the behaviour I was looking for when we bought them.

There are some passive funds which have style tilts but we have been disappointed in their performance, despite their low cost.

Unfortunately, the difficulty for a private investor without the sort of access to fund managers we enjoy, is identifying the above factors in a fund. I would therefore reiterate the point I made at the beginning.

If asset allocation accounts for around 90% of the variance of your portfolio returns and things like fund selection account for 10%, on which part of the investment piece should you spend most of your time?

Concentrate on getting your asset allocation right, making sure it matches your objectives and risk profile. If you have the time and inclination to look for active managers then make sure you bear in mind the factors which might help.

Mike Deverell is a partner at Equilibrium Asset Management in Cheshire. The views expressed in this article are his and do not constitute investment advice.

16 comments so far. Why not have your say?

Law Man

Nov 19, 2015 at 15:52

At a superficial level, this article omits two important aspects:

(1) Allocation between equities and other assets e.g. bonds, real property, infrastructure. To read it without knowing you would think shares in funds are the only asset.

(2) Geographic allocation: how much to UK, USA, rest of Europe, Asia ec.

'Passives' as in ETFs can be used to hold bonds, infrastructure, and real property.

Many advocate a 'core and satellite' approach with 'passive' ETF trackers for FT100/ 250, S&P500, and DAX30, and for Corporate Bonds; supplemented with carefully chosen ITs & OEICs for Asia, infrastructure, health care etc.

Yes, allocation between mega cap, large, mid and small is important; but that is no more important than the above factors.

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Ed the 5th

Nov 19, 2015 at 18:54

"Finally, only a fund with a reasonably high 'active share' will have a chance of beating an index."

A passive investor is not intending, or trying, to beat the index.

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Frank Frank

Nov 19, 2015 at 23:54

Of course Deverell is against trackers. They are simple, immune to manager risk and all research here and the US shows they overperform active funds by a large margin. But having no manager risk, they do not need IFAs and Deverell is not for killing his golden goose for you.

An active fund invested in now and charging 1.5% annually (ECF) will take 45% of your fund by the time you retire 40 years later. Incredible but true.

But you will not be able to complain to Deverell. He will be sunning himself at the French Riviera.

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Frank Frank

Nov 19, 2015 at 23:54

Of course Deverell is against trackers. They are simple, immune to manager risk and all research here and the US shows they overperform active funds by a large margin. But having no manager risk, they do not need IFAs and Deverell is not for killing his golden goose for you.

An active fund invested in now and charging 1.5% annually (ECF) will take 45% of your fund by the time you retire 40 years later. Incredible but true.

But you will not be able to complain to Deverell. He will be sunning himself at the French Riviera.

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foolish_mortal

Nov 20, 2015 at 01:40

- What am I trying to achieve? What’s my money for and when do I need it?

To have a lot of money to buy things.

- What return do I need in order to achieve my goals?

A lot.

- How much risk do I need to take to get there?

A lot.

- How much risk am I willing to take?

Very little.

- How much can I afford to lose?

None.

Does this help?

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Hugh M

Nov 20, 2015 at 03:10

Frank, your figure of 45% is misleading. True, manager may take as much as 45% of your initial investment but if you pick your manager wisely, he could return you 500% or more over this time period. In which case you would have 455% profit.

Arguably the best UT manager, Neil Woodford, made 20% last year alone with his UK Equity Fund which is well up on current year to date. This fund also paid a 4% dividend last year. This is but one active fund with a first class manager, Smith, Train and Burnett are also well worth looking at.

My actively managed funds are all "in the money" for the current year after charges, whereas FTSE 100 is 3.33% down before any charges.

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Mikesmusing

Nov 20, 2015 at 12:14

Frank is correct in that charges of 1.5% a year will leave you with 45% less after 40 years than if no charges were applied. Low cost trackers eliminate a lot of those charges and very few managers outperform over long periods sufficient to cover their charges.

Charges matter. Beware platform provider charges for the same reason.

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sgjhaghsdg

Nov 20, 2015 at 13:37

I agree that asset allocation is critical, which is why I read a few good books on the subject before going DIY. These books also went through the evidence for active versus passive, which is why I'm now almost entirely passive. TBH it's easier to get your asset allocation right with passive building blocks as active funds tend to change their remit, invest outside their sector, merge, demerge, or simply shut their doors, with alarming regularity. I'm sure some have the patience to keep up with tracking the performance and perambulations of active managers, but I don't.

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Maverick

Nov 22, 2015 at 16:00

Foolish Mortal - You, like very many others, use the word "risk" as if it were a fixed, easily defined term. What do you mean by "risk"? Are you not confusing it with volatility? And does volatility matter if you have a long time to smooth out the dips and peaks?

"Risk" changes considerably depending on whether you're working or drawing a pension.

If you really can't afford to take any risk, you will be one of the poor folk buying an annuity and being totally ripped-off by the insurance companies. Your choice. But before you buy it, go on to that brilliant website that works out compound interest and find out how little return you need over 20 or 30 years to beat an annuity provider . . . .

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david mann

Nov 22, 2015 at 21:37

There will always be managers that outperform the average, that is what makes a market. The problem Mike Deverell and all the others like him face is that he has no idea which managers will outperform this year, next year or the year after.

In an average basket of funds he selects for his clients, one or two will do well that year (usually by luck rather than skill,) most will sit around the benchmark/index and a number will have underperformed the market.

Net position for said clients, a return that broadly matches the index return, minus the costs of the funds, moving them around, tax, stamp duty, CGT, spreads, market impact costs - as well as Deverell's own fee on top.

As Warren Buffet himself said, for the vast majority of private investors the best solution would be to buy a spread of low cost index funds, leave them in place and go do something more interesting than following the stock market!

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richard tomkin

Nov 23, 2015 at 09:01

If you can't beat the index,join it.

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Mike Deverell

Nov 23, 2015 at 10:55

Thanks for all the comments on this article – all much appreciated.

I would point out that this is not meant to be a pro active fund piece. The main thrust of the article is that whether you go active or passive is not actually that important when compared to asset allocation. I have previously written for Citywire why I actually think most private investors should use passive funds: http://citywire.co.uk/money/why-im-sticking-to-my-guns-on-passive-funds/a801189

If you do want to use active funds there’s a few things you need to look for to have any chance of picking a good one and hopefully there’s a few pointers there.

I would take issue with Frank’s assertions. He seems to think all financial advisers take high levels of commission – I wish I was sunning myself on the Riviera! We have been 100% fee based for a long time and commission has now essentially been banned. You should never be paying 1.5% for an active fund, the going rate is around 0.75%.

Foolish_mortal you badly need to do some financial planning! Most people invest for a goal in mind rather than to have as much money as possible. If that’s your goal then you’d be better putting a £1 a week on the lottery rather than investing (especially if you can’t afford any losses).

A typical goal might be for your investment to provide an income in retirement. Most people have an idea of what sort of income they might need to fund the lifestyle they want. If you work back from there you ca work out what return you need and tailor your investment accordingly.

Finally, I totally agree with sgjhaghsdg (typing that was hard!) – focus on your asset allocation and read up on the subject before doing it. Perhaps for my next piece I’ll try and focus more on how to construct a suitable asset allocation.

Again, thanks for all responses.

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Law Man

Nov 23, 2015 at 15:35

Mike D: I would welcome an article on asset allocation; but with reasons for choices in the current market climate. Given most (?) of us seem to be aiming for draw down, we shall have a long term investment period, not stop at age 65.

Purely for myself, I thought Foolish Mortal was being humorous: I found it funny, anyway.

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sgjhaghsdg

Nov 23, 2015 at 15:47

Bernstein's "The Intelligent Asset Allocator" is great because it wasn't written in the current climate, and it therefore makes you realise that things change, often quickly and unpredictably, so you need a "portfolio for all seasons".

Hale's "Smarter Investing", is UK-centric and very up to date (get latest edition!) so many will relate to it better, but I liked the historical view that Bernstein gives.

Read both!

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Mike Deverell

Nov 23, 2015 at 16:00

Law Man- thanks. I also thought Foolish Mortal's post was funny, but you'd be surprised how many people actually do think that way!

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Hugh M

Nov 24, 2015 at 05:08

Mike D. Thanks for an excellent and thought provoking article which has drawn some very interesting responses. Can hardly wait for the article on asset allocation.

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