Why pay more for active fund management?

The answer is that if you choose the right active fund manager, the gains you can make far outweigh the costs. Take the top 10 active funds in the IMA UK All Companies sector over the past 10 years. As the chart below shows they have hugely outperformed the FTSE All-Share Index, returning 117.7% on average compared with just 26.9% from the index.

Passive investing, through index ‘tracker' funds or exchange-traded funds, has become popular in recent years with some investors, although active funds still far outnumber them. Called ‘passive' because no thinking is required, they aim simply to track the performance of an index. They provide a cheap and easy way of investing in the stockmarket, and with no risk of seriously underperforming the market.

But as we can see when the average passive fund is added to the chart, you get a very average return - just 16.0% over the 10 years, but slightly below the index due mainly to the fees paid.

The key to substantially higher returns over the long term is independent thinking - informed, rational decision-making about companies and their prospects. What you pay for with active management fees is the expertise of an investment professional skilled in spotting inefficiencies in the market and taking advantage of those through effective stock selection.

Why be a slave to the market? The market is inefficient - it mis-prices companies. The good can be cheap and the bad, even the ugly, can be expensive. Passive investors are forced to hold the few large stocks and sectors that dominate market indices. This can sometimes lead to the heaviest losses, such as those from the banks that weighed heavily in the FTSE 100 Index during 2008. This concentration in certain stocks and sectors can be extremely risky.

Costly, too! When the index rebalances, trackers are forced to sell departing stocks (at their cheapest), and to buy those that are entering (at their most expensive). Would you do that in any other business?

Unlike passive funds, actively managed funds are not tied to stock or sector weightings determined by an index. The manager can take informed investment decisions on companies and sectors, and go where he/she sees the best valuation opportunities. They have the flexibility to quickly react to changing market conditions and, for example, move out of poorly performing companies to preserve value during falling markets.

Also, they can look at the bigger picture - to decide which are the key themes and structural shifts in economies or consumer behaviour that have major investment potential. They can focus on the fastest-growing parts of the world, like China and India - either directly in local companies, or indirectly, in Western companies operating in these regions. There is a wide variety of active funds covering many investment goals and risk profiles to suit most investors.

But not all active funds are equal. In a population of around 5,000 active funds available in the UK, how do you go about picking one who will consistently outperform?

It's all about making an informed choice. Successful active fund managers have a number of things in common - the discipline and patience to invest for the long term, the experience of seeing all types of market conditions, the resources to make the right stock selection decisions, and the freedom to develop their individual strategies and back their conviction.

Look for an active fund manager with proven ability to outperform the market, one with a consistent track record, and who is independently recognised.

No one has ever said that finding a good active fund manager is easy. However, by putting in the same time and effort as you would into any other major purchase in your life, the results can be extremely rewarding. So why pay more for active fund management? We would argue that you cannot afford not to because the good ones are worth their weight in gold.

_{For Financial Advisers only. Not for onward distribution. No other persons should rely on any information contained within this article. Source of performance: Morningstar, Inc., IMA UK All Companies sector as at 26.02.10. Figures in GBP, bid-bid with net income reinvested, basic rate taxpayer. Average performance of passive funds based on the 32 passive funds in the sector with a 10 year track record. This Financial Promotion is issued by M&G Securities Limited which is authorised and regulated by the Financial Services Authority and provides investment products. The registered office is Laurence Pountney Hill, London, EC4R 0HH. Registered in England No. 90776.}