You’ve decided you’d like to invest in shares for the longer-term, and would rather invest in a managed fund over investing in individual companies. There’s one more choice you have to make – whether to invest in an active or passive fund.
What is an active fund?
- An active fund employs a fund manager and team of analysts who research industries and companies and who ‘actively’ choose which ones to buy, hold and sell at any one time.
- The fund manager is hoping that they can beat their benchmarks (usually an index – see below) by buying the winners and avoiding the losers.
What is a tracker (or passive) fund?
- A passive fund simply buys shares in many of the companies in an index e.g. MSCI World Index (the index that you track with your Moneybox equities).
- Instead of trying to identify winners and losers it simply replicates the performance of the index.
What is an index?
- It’s a segment of the stock market, based on factors such as size, or industry or location. For example, the MSCI World Index is made up of the largest 6,000 listed companies in the world.
What’s better – surely active managers do better than a tracker fund?
You’d think that a team that spends their working day researching companies would be great at picking the winners and losers. Surprisingly, the opposite is the case. As the chart below shows, the majority of active funds do worse than the index they’re trying to beat. Here’s a chart that explores the failure of active fund management to outperform the index or benchmark. It shows the percentage of active funds that did worse than the benchmark (i.e. US Large Cap or Emerging Markets index).
So why is this?
Two reasons. First, that fund manager and team of analysts we mentioned are very highly paid, and these costs are ultimately covered by you – the investors of the fund – and over time these costs eat away at your performance. Second, picking winners is really tough. Predicting the future is hard, and it’s easy to get wrong-footed by the daily market gyrations…
Costs can eat away at your returns so reduce them where you can
Here’s a hypothetical example of what you’d lose if you were to pay 2% in fees for your fund over a 25 year period, versus no fees (which is never the case but useful as a comparison). This includes direct expenses and also the amount you lose because the money you pay in fees isn’t invested.
Quiz: To draw attention to the benefits of simple tracker funds Warren Buffett, often considered the world’s most successful investor, bet that a tracker fund (that tracked the S&P 500) would outperform a basket of five complex hedge funds over a 10 year period.
- He won! During the course of the bet, the S&P 500 tracker fund made gains of 7.1% per year compared to Portege Partners’ 2.2% per year.
- He lost! The actively managed hedge fund beat the tracker fund
- There was no real difference between the two
Quiz answer: 1
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is not a reliable guide of future performance.