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Active v passive investment
When it comes to choosing funds in which to invest, it helps to have an understanding of the difference between active and passive investment.
Fund managers who are responsible for running equity portfolios employ a strategy that is either active or passive. The terms describe how portfolios are managed with regard to their benchmark indices.
Indices are used as a measure of how an asset class is performing. In the UK, the best known equity index is probably the FTSE100 which represents the 100 largest quoted companies in UK.
The Dow Jones, S&P 500 and the Nasdaq are the equivalent highest profile indices in the US. In Japan it's the Nikkei.
The movement of an index (either up or down) is used as an indicator of the strength or weakness of the financial market it represents.
The performance of an investment fund is compared with the performance of a benchmark. This is usually the index that represents the same kind of assets that the fund holds. For example, UK equity funds would be measured against a FTSE index, government bonds would be measured against a gilts index and property against a property market index.
Active managers try to perform better than the index they are measured against. Passive managers simply try to deliver the same performance as their benchmark index.
How the active managers do it
An investment house employs talented fund managers as active managers, to use their skill to invest in a selection of the assets from within their benchmark universe to deliver better performance than their universe as a whole. These skilled professionals are expensive and therefore if you invest in these funds you will be charged higher management fees in return for the extra value they will (supposedly) add.
However, there is a significant body of evidence suggesting that active managers usually fail to outperform their benchmarks. Part of this is simply because of the fees they charge (fees paid reduce the total return on the fund) and part is because there are actually not very many truly skilled fund managers! There are very few fund managers who have the record of consistent outperformance of someone such as Warren Buffet.
And even if there are some fund managers out there who can outperform, how can you as an investor be sure you will pick the right one? As the investment literature always says - "past performance is no guarantee of future performance".
How the passive managers do it
The simplest way for a fund manager to ensure their performance matches the benchmark, is to invest in everything that is in the benchmark, in the same proportion that it is in the benchmark. The best way to do this is to use a computer.
Computers can be programmed, for example, to buy shares in all of the 100 companies that make up the FTSE100 index or the 500 companies that comprise the S&P 500 index in exactly the right proportions. Using computers to do most of the work is very cost effective, so passive funds can manage large amounts of money at a very low cost. If you invest in a passive fund (also called "index" or "tracker" funds) the fees will be relatively low.
Exchange Traded Funds, or ETF's, have recently grown very rapidly as a form of passive investing. Buying shares in an ETF is effectively buying a small slice of a fund that is replicating an index for a particular asset class. There are now ETF's for almost any asset class you can think of, from mainstream equities all the way to more esoteric areas such as diamonds, fine wines and antiques!
The gloves are off
So which is best, active or passive? Well evidence suggests that for popular asset classes such as equities or bonds, where the choice is really about which geographic market you want to invest in, a passive approach is likely to deliver better long term returns (the longer the investment period, the more beneficial is the impact of very low fees).
However, for those who can afford to take more risk or who want to invest in more specific market areas, for example smallcap equities, emerging market bonds or particular industry sectors, and who have the patience to research the active managers that are available, active management can be successful. It is just less predictable and costs more!
Source: Time For Money