Passive investment is the way to go

Actively managed funds are often tipped as best to invest in as the ‘in the know’ fund managers can predict future economic trends and share price movements. But their track record doesn’t always live up to the hype, which is why being a passive investor could be more profitable.

Passive investing shows that being a little laid-back is often the route to long-term success. Karan Kapoor

With most things in life it pays to be active, but that is not always the case when it comes to your investments.

So-called passive investing shows that being a little laid-back is often the route to long-term success.

Passive investing involves buying funds that track every movement of a chosen stock market or commodity index, regardless of whether it goes up or down.

There is no expensive fund manager picking stocks or making calls on future economic trends and share price movements, in a desperate bid to beat the market. Instead, investors get whatever the index gives them, minus a tiny annual management fee.

Here’s the shocking thing: passive funds typically beat those hard-working active fund managers three times out of four, and often more. So does it really pay to display passive tendencies?

What is passive investing?

Traditional mutual funds employ a manager backed by a large research team to help them decide which regions and markets to invest in, and what stocks to buy and sell, in a bid to generate greater wealth for investors.

Embarrassingly, it rarely works out that way, with survey after survey showing that 75 per cent of the time they let their investors down.

Over the past 20 years, active funds investing in US large cap stocks beat the index just one year in four, according to fund website Morningstar.

Analysis of 25,000 funds compiled by S&P Dow Jones Indices found that over the decade to January 1 2016, some 73 per cent of active UK funds in the UK and a whopping 86 per cent in the euro zone failed to beat their benchmarks.

2016 has been a particularly poor year, with just 6 per cent of US growth funds beating the US S&P 500 index in the first three months, according to Bank of America Merrill Lynch.

This isn’t just down to incompetence: most funds will hold some money in cash, which can be a drag on performance.

Or perhaps fund managers are trying to do the impossible: Princeton economist Burton Malkiel’s book A Random Walk Down Wall Street suggests share prices move completely at random, making stock markets entirely unpredictable and as such, unbeatable on a consistent basis.

The main reason actively managed funds underperform is down to charges. Employing supposedly clever fund managers and banks of researchers costs money and this is passed on to investors in the shape of pricey initial and annual fees (on top of those charged by your adviser).

Charges can be as high as 5 per cent of the money you initially invest, followed by an underlying 1.5 per cent of your fund’s value year after year. That may not sound much but it can steadily erode your long-term returns.

Say you invest in a fund with an annual charge of 1.5 per cent that grew 3 per cent over the past 12 months: half your gains will have gone in charges. Even if it grew a more respectable 6 per cent you will still have handed over a quarter of your profits.

By contrast, passive funds have zero initial charges and annual fees should never top 0.75 per cent, while some charge as little as 0.07 per cent.

Over the long term, this can make a massive difference. Say you invest $50,000 in a fund charging 1.5 per cent a year for 10 years, and that fund grows at 5 per cent a year.

After a decade, your fund will be worth $70,530. However, if you had invested the same sum in a cheap tracker that charges just 0.5 per cent a year and grew at the same rate your money would be worth £77,650 (Dh380,000), or $7,120 more. That is equivalent to an extra 10 per cent.

Over longer periods, the difference is more marked. After 20 years you would have £120,585 with the low-cost tracker, $21,096 more, and after 30 years the tracker would give you £187,266, which is $46,927 more than the active fund. That extra 1 per cent in annual charges does disproportionate damage over time.

If your tracker charged just 0.07 per cent a year you would have $211,817 after 30 years, an incredible $71,478 more (and remember, you only invested $50,000 originally).

New figures show that low-cost tracker manager Vanguard has saved investors $175 billion in fees since it was founded in 1974, compared to the average expense ratio on active mutual funds.

Making tracks

The message is getting home to investors, who have been actively showing their appreciation for passive funds.

Exchange traded funds (ETFs), low-cost trackers that can be bought and sold like shares, attracted nearly $200 billion worth of new investment in 2015, while actively-managed funds suffered total outflows of $124 billion, according to research company EPFR Global.

This isn’t a blip, Morningstar says assets under management in passive funds have quadrupled since 2007.

The site runs a regular six-monthly Active/Passive Barometer comparing performance between the two fund philosophies and Ben Johnson, director of global ETF research, concluded in April that: “Actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons”.

Active funds have also suffered higher “mortality rates”, which means they were more likely to be merged or closed over a 10-year period, while passive funds were typically more enduring. “The average dollar in passively managed funds typically outperformed the average dollar invested in actively managed funds,” Mr Johnson says.

That is a clear and damning statement for active fund managers, so why are they trailing the trackers?

Again, Mr Johnson’s report concludes that fees are the single biggest differentiator. “Fees matter. They are one of the only reliable predictors of success,” he says.

This does not of course mean that passive funds will always outperform trackers, but it does mean you should think carefully before choosing an active fund.

Passive aggressive

Globally, more than $5 trillion is now invested in almost 4,500 ETFs and Sam Instone, chief executive of Dubai-based independent financial advisers AES International, is a fan of their low cost and simple structures. “Investors choose them because they offer better performance and lower charges than actively managed investment fund alternatives.”

Mr Instone says too many expats in the UAE underestimate the effect of fees on their overall investment returns. “Worse, many fall victim to hidden fees, which can destroy performance altogether. They eat away any gains you are fortunate to make and in the vast majority of cases you are paying for funds that fall short.”

AES recommends ETFs for the majority of its clients. “The index funds we recommend beat 97 per cent of actively managed funds. And of those few active funds who do outperform, the majority recoup in fees any value they add, leaving little or nothing for the investor,” Mr Instone says.

The simplest way UAE investors can turn ETFs to their advantage is to track a major global index such as the US S&P 500 or FTSE 100. “These are simple and effective although they won’t track an index perfectly due to the costs of running the ETF. The iShares range is the most popular, with typically charges of between 0.07 and 0.50 per cent a year.”

Alternatively, you could invest in a balanced portfolio of passive funds designed to achieve a specific investment target.

Vanguard LifeStrategy, for example, offers low-cost fund portfolios with different objectives, for example, investing for income, conservative growth, moderate growth, and so on.

Fund manager BlackRock has a passive range of Managed Index Portfolios which offer growth, moderate or defensive strategies.

AES runs its own “White List” of recommended ETFs which include funds such as iShares MSCI World, which gives you global exposure, and further iShares funds targeting emerging markets, the Pacific, Japan, the S&P 500, FTSE 100, as well as funds tracking bond and property markets. You can also buy ETFs that track commodities, such as oil and gold.

Mr Instone says ETFs are typically created in two separate ways and it is important to note the difference.

Some are “synthetically” created with derivatives while others are “physically” backed with the underlying stocks, he says. “We only recommend physical ETFs as these are relatively less risky. During the 2008 financial crisis a lot of synthetic ETFs went bust when Lehman Brothers went bankrupt, as it was the counterparty to the derivatives.”

So check your own investment portfolio to see if it is full of underperforming active funds charging hefty fees. If it is then ask your adviser some serious questions. Don’t hang around, it may be time to get a lot more passive.

Mix and match

Tom Anderson, a regulated investment adviser at Killik & Co, which has offices in the UAE, charges a fee for advice rather than earning commission from fund managers so has no financial incentive to favour one fund type over the other. “I use both active and passive funds for different areas because each has its advantages and disadvantages.”

Mr Anderson uses ETF trackers to invest in major Western stock markets such as the US S& P 500, the EuroStoxx 600 and the UK’s FTSE 100. “It is very difficult for an analyst to find an undervalued opportunity in these markets as they are so heavily researched, so I use low-cost ETFs instead.”

Mr Anderson says trackers do have drawbacks, because they must buy whatever company is currently in their chosen index, regardless of its balance sheet or future prospects. “This means they may have to buy unattractive assets just because they fit the index criteria.”

The adviser says active funds are much more selective and can therefore be a superior way of targeting specialist sectors. “This might include areas like smaller companies, emerging markets or dividend-paying stocks. Some managers have an investment mandate to identify standout opportunities and outperform the index that an ETF can only track slavishly.”

Some of the best managers invest their own money into their funds, so their interests are closely aligned with yours, Mr Anderson adds. “Fees are higher but they do also offer the potential for outperformance, whereas by its very nature an ETF can never beat the market.”

Active funds may have a higher closure rate than ETFs but Mr Anderson argues there is good reason for this. “The unrelenting competition between active fund managers and competition from passive funds has led to a survival of the fittest, as managers have had to prove themselves over many years.”

By targeting proven winners you can back the handful of managers who beat passive funds, he adds.

Mr Anderson rates managers Terry Smith, who runs Fundsmith Equity; Crispin Odey, founder of Odey Asset Management, Jonathan Ruffer at Ruffer and Neil Woodford, who manages CF Woodford Equity Income. “They come with decades of experience and the flexibility to adjust as market conditions evolve – which they can do, very quickly – whereas an ETF is absolutely tied to the index it tracks,” says Mr Andersen.

Tom Stevenson, investment director at fund manager Fidelity International, argues that active management still has its advantages. “Active stock pickers can sort the wheat from the chaff, ensuring that not only the best quality investments make it into the fund but equally, avoiding any companies that are vulnerable in an unsettled market.”

Unfortunately, too many fund managers are closet “benchmark huggers”, which means they play safe (and keep their jobs) by quietly tracking the benchmark index rather than trying to beat it, while charging investors a hefty fee for the privilege. This is the type of “active” manager you should avoid, one who is essentially passive.

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