An active or passive fund? It all depends on the type of investor...

Active management may generate better returns than trackers, but the costs and risks are higher. Rob Griffin on a long-running debate

It is one of the longest-running debates in fund management: are people better off following passive investment strategies, or should they invest with active managers to improve their chances of enjoying top-drawer returns?

Unfortunately there is no simple answer because the two distinct approaches suit different investors. Those wanting low-cost exposure to the stock market will be drawn to passive funds, while the more gung-ho are likely to prefer actives.

Patrick Connolly, head of communications at AWD Chase de Vere, agrees that there are pros and cons. "The question is whether you will benefit from paying the extra charges of an active fund," he says. "If the answer is no, you should use passive."

But what can you do to establish whether a fund will be cost-effective? The answer is that you will need to properly compare the two styles, understand the comparative risks involved, and then consider how much each one is likely to cost.

What are passive funds?

Passive really means so-called trackers whose objective is to mirror the performance of a given stock market index. Their managers will ensure that the fund they are constructing simply replicates the index that it's tracking.

The variety of tracking funds available in the market has grown enormously over the last few years. While a decade ago you would be limited to, say, a FTSE 100 or All-Share tracker, today you are virtually spoilt for choice.

According to Andy Gadd, head of research at Lighthouse Group, index trackers can reasonably be termed "bloodhound funds". "This means that they sniff the market all the way up and all the way down again," he explains.

That's not to say that trackers should only be used by inexperienced investors wary of markets. They can certainly be useful to all sorts of people, irrespective of their knowledge or understanding of markets.

"Whatever the climate, even the most experienced investor can benefit from having a tracker as part of their core portfolio for one simple reason: cost," he says. "Unlike active funds, with a tracker there is no manager or highly skilled bank of analysts to pay. Essentially it comes down to something of a black box."

Fees are one of the main differences between passive and active fund management. As they require less day-to-day management – and do not incur the costs of constantly buying and selling shares – trackers should have much lower charges.

Most will actually be free to set up and subsequently cost less than 1 per cent each year to manage. This compares to active funds, for which investors can pay 5 per cent initially, and then an annual charge of at least 1.5 per cent.

You first need to decide what you want to track – and which index is the most suitable way to achieve your goals. For example, if you wanted to follow the US equity market, you can choose between various indices, such as the Dow Jones Industrial Average or S&P 500. Therefore, you will need to consider the constituents of each index to see whether it will suit your investment needs.

However, you will need to accept that performances can even vary between rival funds following the same index, as it all comes down to how they are structured; while it is worth remembering that trackers are not risk-free, as they are inextricably linked with the fortunes of the stock market, points out Andy Gadd.

"A neat branding of either style as high or low risk is out of the question," he says. "For example, how could a Japanese tracker fund ever be described as low risk?"

What are active funds?

As their name suggests, managers of active funds are able to buy and sell holdings with the intention of maximising gains and minimising losses. This means they can react to unforeseen events quickly. Within the scope of their funds they can make calls on the market and ensure that they have exposure to the stocks and sectors that they think will perform particularly well in a given environment.

The extra work and analysis involved means investors will have to pay more in the way of costs. However, it is hoped that success enjoyed by the manager will far outweigh the negatives of having to hand over a bit more cash.

Whether or not they are successful depends on factors such as their natural ability and the quality of the fund management group's research analysis, according to Justin Modray, founder of the website Candid Money.

"The fact is that the majority of active managers tend to lag trackers in most conditions," he says. "The reason is that in large developed markets like the UK, most companies are so well researched it's hard for a manager to gain an edge through spotting opportunities that others have missed."

To improve their chances of generating bumper returns, therefore, they will often take big sector and/or company positions versus the index. "The problem is some managers are not keen on taking such risks which others do and get it wrong," adds Modray. "Add in the high annual charges of active management and it becomes even more difficult for a manager to beat the index."

However, active managers do have greater success when investing in niche areas which are not so well covered, while there are also some types of investment for which trying to construct a fund that tracks an index is impractical, such as property.

"The IPD UK All Property Index is calculated using over 3,500 commercial properties," says Modray. "It simply wouldn't be possible for a commercial property tracker fund to own this many properties, if any at all. That's why we've yet to see a meaningful physical property tracker fund."

Investors wanting to go down this route will also need to decide to which parts of the world they want exposure – and then analyse the funds covering those areas. As always, taking a close look at the underlying holdings is important.

What do clients want?

Geoff Penrice, a financial adviser with Honister Partners, generally prefers an active strategy as he believes that by picking well-managed funds he will give his clients a better return than would have been possible via a "passive" strategy.

"However; there has been an increase in demand from my clients for a 'passive' strategy so I offer both," he adds. "I am sure that the demand for 'passive' strategies will continue to increase as it is the difference between cost and value."

"In terms of portfolio construction and investing we consider both passive and active," says Andy Clark, managing director, wholesale (UK), HSBC Global Asset Management. "Both have a place in a client's portfolio so it's horses for courses," he says. "What passives give you in market exposure and low cost, active gives you that stock selection angle. The strategies complement each other; they are not at war."

Which works best in the current market?

The performances generated can also vary enormously depending on the market conditions, points out Geoff Penrice, although both strategies should give medium- to long-term returns above inflation and cash.

"Periods when markets are performing well tend to benefit passives as they can tap into the growth at a lower cost," he explains. "Volatile periods or those when markets are falling will tend to favour active portfolios as they can adopt a defensive stance."

However, that's not always the case, argues Patrick Connolly at AWD Chase de Vere. As in any area some people will be better at their job or not so affected by the economic backdrop. "In all market conditions there will active managers who do well and active managers who do badly," he says. "There is no evidence that an active strategy performs better in any specific environment."

How will the market develop?

According to Andy Clark at HSBC Global Asset Management, investors are crying out for simple, cost-effective solutions that they can understand.

"The industry offers such a wide choice that it can be very confusing for people," he says. "We're keen to see the market kept simple rather than seeing the launch of numerous index funds trading every weird and wonderful market."

It is an issue he believes product providers must address. "We need to get Britain saving," he adds. "We all need to be putting more money away, yet people are put off by the confusion, complexity and charges involved."

Active and passive funds that could be worth a look

We asked financial advisers and commentators which funds they liked:

Geoff Penrice: "I use multi-manager funds such as the Jupiter Merlin Income fund and the Henderson Income & Growth fund. These are actively run portfolios which have higher charges than individual funds but they have provided consistently good returns on a low-risk basis."

Andy Gadd: "In the current economic climate I currently like the Artemis Strategic Assets fund which is an absolute return fund. It uses different asset classes in search of superior returns."

Patrick Connolly: "For the UK market I would identify L&G UK Index (passive) and active funds such as the Schroder UK Alpha Plus, Newton Income and L&G Growth."

Justin Modray: "There are plenty of low-cost unit trust trackers such as HSBC FTSE All Share tracker. Interesting actively managed funds in the current climate include Schroder Income Maximiser and Standard Life Global Absolute Return Strategies."