Active funds' true worth lies in their diversification benefits, writes Rob Gleeson, head of research at FE.
Active management has been getting a bad rep lately. The onset of the Retail Distribution Review (RDR) has brought fund charges firmly into view, and all the predictable noises are being made about how much better value passive funds are.
But this view fails to take into account the full benefits of active funds and how, when they are used correctly, they offer much better value for investors, regardless of fees.
There has been plenty of research into the benefits of active management, some favourable, some not. The widely accepted conclusion however, is that, on average, most active funds fail to beat their benchmarks and only end up providing market-like returns over the long term.
Active funds’ true worth lies in their diversification benefits
Conventional wisdom goes therefore, that if you are only receiving market-like returns, why pay a fund manager to generate it when tracker funds and exchange traded funds (ETFs) can produce the same returns for less?
This overstates the case and ignores the considerable number of excellent funds and managers that consistently beat their benchmarks. The above argument also assumes that the average return over the long run is the only important factor in comparing the performance of active and passive funds.
What is more important is the journey each fund takes towards producing its returns. For a passive fund, the road will be relatively uneventful. The fund will broadly mirror its underlying benchmark, never deviating by more than a few basis points each month.
This is only true of the best passive funds (there are some truly awful trackers that do not even try to replicate their benchmarks) but let us assume that passive funds in this instance are all as virtuous as the best, such as Vanguard’s, which track exceedingly closely to their markets and charge very little to do so.
The journey of an active fund will be markedly different. With active funds you are paying a fund manager to take risks on your behalf, to make sector and stock bets and try to beat the market.
Generally speaking, this will lead to much more volatile returns; sometimes these bets will come off and the fund will race ahead of the market, and at other times they won’t and the fund will fall behind.
The overall result is that, more often than not, these bets cancel each other out, but that does not mean they are without value.
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