A personal finance dilemma every investor faces is whether they should put their money in an active vs passive investment. Active investments require a manager to monitor the market constantly to make profits, whereas passive investments merely track a market portfolio and mimic its performance against its benchmark to grow capital. The distinction is important as they both influence the returns on investment.
The reason for analysing this topic is based on the assumption our investors are also investing in mainstream vehicles, such as stocks, bonds and alternative investments (e.g. mutual funds, index funds, and exchange traded funds). It is not only meant for experienced investors but also for people who have never invested. The aim of this article is to provide a summary of the strategy of various research and studies on the distinction between active and passive investments for both experienced and new investors.
Factoring the following conditions will not only clarify the goals of your investment but also, should you decide to invest in actively managed funds, help you avoid falling for the common pitfalls of actively managed investments:
The consensus on actively managed funds (both actively managed mutual funds and actively managed index funds) is that it has higher fees than passively managed ones because asset allocation in active fund done manually. Fund managers are actively picking individual stocks and mutual funds, trading them around the clock to boost profits. Fees in actively managed funds can range from 0.5% to 2.5% on a year period, and passive index fund and mutual fund only cost about 0.2% or lower. The difference may appear small; however, a portfolio manager fees under active management can amount to thousands in the long term and take a significant portion out of the investors' profits.
Market research has shown that active management fees compound too and lower returns on average by 29%. Even a 1% fee would cost an investor around 500,000 EUR over 40 years, compared to 180,000 EUR for passive index fund and mutual funds. Since only a small number of actively managed funds yield generous returns, most profits generated out of active management will be far below the expense ratio. Moreover, fund managers will be inclined to take more risks to get higher returns to compensate for their higher costs.
A study done by SPIVA found that 70% of European active equity funds underperformed in 2019, while its passive peers (index funds and mutual fund) outperformed by 1.5%. 78% of active funds generated lower ROI over five years, and 87% could not catch up to its passive counterparts under S&P Europe 350 over ten years.
If active investments are so costly and lower profit returns, why do still many investors hold actively managed funds and have active managers? The reasons are more complicated. Despite all the drawbacks, several factors and circumstances have led to actively managed mutual funds and actively index fund investments performing better than passive investments.
Studies have shown that the lowest-cost actively managed funds do better than the average passive investment vehicles over the long term. High-cost active funds do worse against passive funds because of their high fees.
Examples of some of the lowest-cost active investment vehicles are:
Global real estate funds generated 1.2% more in ROI than its passive competitor over the last decade. Large capital value stocks outperformed index fund by 1.13% on average.
The study, however, is not conclusive, and there is research that suggests otherwise:
The success or failure of active funds largely depends on the circumstances, costs, active managers skills, and type of funds.
The success rate of active investment is roughly 50% during the first half of the year, depending on the assets themselves, the market conditions and the manager's skills.
The reality is, only 6% of actively managed fund outperform the market in Europe. Therefore, the question is not whether you should solely invest in active or passive funds for better financial performance but whether you should try to beat the market. One reason people tend to stick to active funds is that they believe they can beat the market index. We do not deny that you cannot, but we believe that it, along with past performance, is not a guarantee of future profits, and you should be aware of factors to avoid risk.
For instance, in the active stock market, you can invest in small-cap stocks issued by companies valued between 300 million to 2 billion EUR because the stock is cheaper than large-cap stocks issued by bigger companies. There is an opportunity to beat institutional investors in the stock market here since small-cap company stocks have performed better than large-cap company stocks for investors. However, small-cap company stocks are also more volatile and therefore investing here carry financial risk. If you are comfortable investing with the financial risks, there is no reason to be deterred from investing in them through companies. With proper research, investing in small-cap stocks can be worthwhile, provided that your ROI goals are worthwhile for the long term.
If there are differing results out of the studies, does this mean that investors should ignore investing in them and pick any portfolio they wish? Not at all. Just because there is contradictory portfolio investing outcomes does not mean that the studies done are useless. The data collected out of this pattern may very well favour a portfolio strategy in their personal finance at picking better funds for good performance or pick good managers.
Last update: 06/05/2021