Active or Passive investments?

The active or passive investments discourse has a long history. There’s an old saying that doing nothing is an active decision. We don’t know if this applies to those investors choosing to put more and more of their money into passive funds. Whatever the reason, I think they’re right to be sceptical of active funds.

Passive popularity

More people are choosing to be passive. That might sound curious in a world that praises action, decisiveness and resolve.

Here, of course, I’m talking of course about the different ways you can have your money managed.

You can pay someone to manage it for you. They will use guile, experience and insight to try and beat the stock market. That’s known as active investing. The (high) fees aim to compensate the manager for their expertise.

Or you can choose someone – usually plus a computer – who tracks the market’s ups and downs. This is passive investing. Fees are compensatory – but much lower.

Then there’s the middle ground. This comes in many guises, but the best options are systematic investment styles that give you cost-effective, above market returns.

More on each approach in a moment. But what piqued my interest is that there’s now 20% more investor money in passive funds compared with a year ago. If you look at money in funds overall – the aggregated investments of you, me, our employers’ pension funds, big insurance companies and others – they only grew by 6%.

If you drill down into what people are buying, they paid £1.46bn into passive funds a year ago. Now they’re paying about twice that (£2.89bn).

Passive is popular.

Passive perfection?

Academics love to show that active funds can offer investment returns better than the market – but rarely back that up with repeat performance.

One of the shorter, more recent (and readable) papers on the subject is here. It finds, “in the … period from 1994 to 2018, the best-performing mutual funds from the previous year no longer earn significantly positive one-factor alphas in the following year.”

Academics would never actually write, “it’s all luck,”  when they’re showing how patchy active fund performance can be. But they probably think it.

After all, as this periodic table-style chart shows, it’s unusual for one part of the market to perform well for consistent periods of time. Far better, in my view, to just buy the market … plus a few tweaks.

Passive plus

The weight of evidence suggests passive funds do better than active funds over the long run. Should you actively put all your money into passive?

I think you need that middle ground.

That’s because further evidence says certain factors – or characteristics – of stock markets tend to perform better over the long run than others.

For example, smaller companies tend to offer better investment performance than larger ones. There’s an index, or basket, of smaller companies tracked by the bank Deutsche Numis. They say had you put money into smaller companies in 1955 you could have almost 400x your original investment, in real terms. The same money in UK larger companies would be worth around 60x.

So that’s why we like passive funds with what you might call a twist.

And other of those twists are emerging markets companies (from China to Brazil – rather than say France to Canada) and undervalued companies (as opposed to growing ones).

This efficient, rules-based and objective approach is almost always going to beat a smart human who thinks they’re cracked the secret of consistent active performance.

Such incremental returns can often offset the cost of investing over the index-tracking approach.

If you like the idea of building wealth with evidence on your side (and there’s plenty more evidence I could have cited) then please get in touch on hello@firstwealth.co.uk or call 020 7467 2700.

[1] https://www.theia.org/sites/default/files/fund-statistics/March-2024%20Monthly%20Press%20Release%20vFINAL%201.pdf

https://cfr.pub/published/papers/choi2020carhart.pdf

[2] https://cfr.pub/published/papers/choi2020carhart.pdf

[3] https://www.callan.com/research/2023-classic-periodic-table/

[4] https://dbnumis.com/#:~:text=The%20index%20was%20created%20by,term%20outperformance%20of%20smaller%20companies.

This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.