Richard Wallis, head of research and investment at Origen
Passive investing is most often viewed as an index tracking investment strategy and in its simplest form, a passive index tracking fund attempts to match the performance of a particular ‘index' of shares. This means that the fund will attempt to grow as closely as possible to the growth rate of that particular index. Index tracking is known as passive because the manager is not normally making significant decisions about which companies to buy and sell and is instead simply following the index.
There are two main methods of index tracking in order to achieve a similar growth rate to the underlying index. The simplest method of tracking is for the fund to purchase all the securities in the same proportion as per the underlying index and this is known as full replication. This method works particularly well for indices where there is not a significantly high number of underlying constituents, eg FTSE 100, and the main advantage of this approach is that you would expect to closely match the performance of the index.
However, if the underlying index has a much higher number of constituents, eg the FTSE All-Share, full replication is more difficult as well as being expensive to operate. The second method of index tracking and one more appropriate for tracking larger indices is statistical sampling. In this method, the manager does not attempt to hold every single index constituent in its correct weighting, but will instead analyse the index and work out a portfolio that they are confident will closely match the performance of it.
In simple terms, active management is an attempt to outperform the market. There are many different forms of active management and most of these strategies rely on either strong stock-picking or asset allocation to drive outperformance of the market. Essentially, an active manager is looking to exploit efficiencies in the market. Some active strategies can be viewed as closet trackers where the performance and underlying portfolio will be similar to that of the index and a low tracking error could be an indication of such a fund.
Both passive and active management strategies have their own advantages and disadvantages. The obvious main advantage of passive investments is the much lower costs. Another point in its favour is that both investors and managers are not required to make any decisions with the former only needing to decide on which index to track.
While tracking an index's performance can be preferred, the disadvantage of this is that investors need to be satisfied with achieving the same return
as the market as this should be the best that any index fund can do.
Furthermore, when taking into account the charges, an index fund should normally marginally underperform the market return. In addition, another often mentioned disadvantage of passive investments is that the manager cannot utilise defensive measures, particularly in falling markets. Consequently, the manager cannot sell a holding if it is thought that the price is going to fall or increase the exposure to more defensive sectors and/or cash in falling markets.
Turning to active management, providing the appropriate manager is selected, investors can gain exposure to experienced individuals who are able to build portfolios based on their experience, judgement and market/economic conditions. Another main reason for choosing an active investment strategy is the possibility of achieving returns in excess of that of the market. Also, and in direct opposition to one of the disadvantages of passive investment, active managers can take defensive positions if they believe markets will fall or sell holdings if there is the belief that the prices will decline.
The main disadvantage of active management is the often much higher fees and expenses. Furthermore, if the active strategy does not result in outperformance of the market, these higher fees only exacerbate the losses.
There is also always the risk that the manager will make the wrong decisions and this can significantly reduce returns.
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