Please note that the views and opinions expressed in this article may be promotional and do not necessarily reflect those of Aviva.
When choosing a collective fund, one of the most important choices an investor will make is between an active or passive approach. While a ‘passive’ approach aims to replicate the performance of a market (as measured by market index), an ‘active’ fund manager will aim to deliver a higher return than the market by selecting individual shares. Each of these approaches has its merits and there is often a place for both in a diversified portfolio. We remind investors that all investments involve risk to both income and capital, whether active or passive approaches are used.
Passive funds come in a number of guises and track a broad range of indices, such as the FTSE 100, S&P 500 or MSCI World. The main indices usually represent the largest companies in a country’s stock market and will be weighted on size, so larger companies have greater representation. As a result, funds tracking an index will give investors a higher weighting in a market’s largest and most liquid companies. In the UK, this would be companies such as GlaxoSmithKline or HSBC. However, tracker funds are also available on indices that weight companies on factors such as dividend yield or revenue growth.
Within passive funds, there are a range of different approaches to tracking the index. Some funds will use ‘physical’ replication – holding individual stocks in the exact weight they are held in the index and rebalancing as the index rebalances, so a FTSE 100 tracker would hold 6.7% in HSBC and 4.2% in Royal Dutch Shell¹ and would adjust those holdings as their relative weighting within the index changed, so that the fund’s holdings continue to be aligned with the index. The other main approach is to use ‘synthetic’ replication – using a derivative to replicate the performance of an index.
A synthetic approach will tend to give closer replication of the index and may be cheaper. However, the derivative is often issued by an investment bank and that can introduce additional risks. Passive funds may be structured as conventional open-ended funds or Exchange Traded Funds, which are listed on a stock exchange.
In all cases passive funds are likely to be cheaper than active funds. They also offer instant diversification and investors know they receive a return close to that of the market. However, active funds also have their advantages: they offer the potential for outperformance of the index and may be better able to defend a portfolio at times when the market is falling, when passive funds will simply track the market lower. Of course, not all active managers will be successful at defending capital in a difficult climate.
While the debate on active and passive investing has often been polarised, the reality may be that both often have a place in a balanced portfolio. There are some markets that suit an active approach and some that suit a passive approach. For example, markets where there are a lot of experts analysing the markets are likely to have fewer examples of mispricing for active managers to exploit. All that is known about a company is likely to be in the price of the shares. This might be true of, say, very large companies in developed markets such as the US, where there is wider participation in stocks markets. In this case investors may be better off with a passive product.
In contrast, there will be parts of the market where active managers can add a lot of value through proprietary research, such as smaller companies or in certain emerging markets. In these cases, an active approach may bear fruit. Investors should always bear in mind that the value of investments and the income from them can fall as well as rise and is not guaranteed. There are no guarantees that investors will get back the amount originally invested, whether in an active or passive fund and the specific risks involved will depend on a fund’s objectives and the type of areas in which it invests.
With this in mind, investors could take one of two approaches – holding a blend of passive funds at the core of their portfolio and then building ‘racier’ active funds around the edges seeking to deliver stronger returns than their given markets over time, or holding active fund at the core and building passive funds around the edges to give added exposure to certain areas. We believe judicious blending of both types of funds within a portfolio can help keep costs lower, while also sustaining the potential for strong performance.
1 FTSE as at 19th August 2015
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Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time.
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