A personal finance dilemma every investor faces is whether they should put their money in an actively or passively managed funds. 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 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 into your investment 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:
- What is active management?
- Best managed investment funds under active management
- Can active managers yield higher returns?
- Should you try to beat the market?
The word "active management" refers to an investor, a professional money manager, or a team of experts who monitor an investment portfolio's performance and trade its assets. Any investment manager's objective is to outperform a specified benchmark while also achieving one or more additional objectives, such as risk management or tax minimisation. Active managers may employ investment analysis, research, and forecasting techniques, which may include quantitative tools.
By contrast, passive management adheres to simple guidelines that attempt to replicate an index or other benchmark. According to passive management, the greatest outcomes are obtained by purchasing assets that replicate a certain market index or indexes. Passive management eliminates the shortcomings of human biases, resulting in improved performance.
Understanding active management
It was normal in the past for professional investors to analyse and choose specific securities in order to build a portfolio that may beat the general market. However, the trend has been gearing towards passive investment due to its low cost and overall better performance than most active investments. While this may be the case, there is still a strong case for actively managed portfolios.
Some investors believe that active management is a good way to make money. They do not believe in the efficient market hypothesis or the "you cannot beat the market" philosophy, because all public information has already been factored into stock prices, making it impossible to get consistent excessive returns over market value.
Active managers will also look at the risk in their portfolio and how well they did at meeting other portfolio goals because many of them may have to deal with risk over shorter time frames.
The pitfalls of actively managed funds
The consensus on actively managed portfolios (both actively managed mutual funds and actively managed index funds) is that they have higher fees than passively managed ones because asset allocation in active funds is done manually. Fund managers are actively picking individual stocks and mutual funds and trading them around the clock to boost profits. Fees on actively managed funds can range from 0.5% to 2.5% over a year, while passive index funds and mutual funds only cost about 0.2% or lower. The difference may appear small, but a portfolio manager's fees under active management can amount to thousands in the long term and take a significant portion 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.
Investing in actively managed funds isn't always the cheapest option, but the correct picks can yield impressive returns. That is, if you recommend the appropriate fund at the right moment. However, since fees impact your returns directly, it is better to pick active investments that are low cost. The following are some actively managed funds examples:
- Junk bonds: Historically, the junk bond or high-yield bond market has been one of the greatest markets for actively managed funds. Over the last ten years, 42.3% of actively managed funds survived and outperformed the average passive fund in their category. The best thing high-yield bond indices have going for them is their low fees. Although high-yield index funds are more expensive than most other types of index funds, they offer a slightly larger cost advantage over active peers in the investment-grade intermediate core bond, intermediate core-plus bond, and corporate bond categories.
- Global real estate funds: Global real estate funds are similar to mutual funds. They mostly invest in REITs and companies that own and operate real estate globally, but some can also invest domestically. They let you get a lot of different types of real estate exposure for a small amount of capital. Because of their strategy and diversification goals, they can give investors a wider range of assets than they can get by buying individual REITs. These funds are easy to buy and sell. Another big benefit for retail investors is the analytical and research information that the fund gives them. This can include information about the assets that the company has bought and how the company thinks about real estate as an investment and as a whole. Investors who want to be more speculative can invest in a family of real estate mutual funds, where they can put more money into certain types of properties or regions to get the best return.
- Foreign stock funds: Investing in foreign equities is a fantastic way to diversify your portfolio and gain exposure to the global market. Foreign stock funds are inexpensive, which benefits contrarian investors who want to save money on their investments. S&P 500 stocks trade at a price-to-earnings ratio of 21 times. Just 15 times earnings are traded on internationally developed stocks. Whether or not active foreign stock fund managers have "better selectivity abilities" is still up for debate. However, during the previous 20 years, the typical actively managed international stock fund has outperformed its relevant index, albeit by a small amount. However, it outperformed domestic stock funds, particularly those invested in large domestic corporations.
- Emerging market funds: In emerging markets, information is more difficult to come by, companies are less well-known, and experts are required to uncover the best ideas. A 2017 research study in emerging market funds indicated that active stock pickers generated returns of 31.8% after fees, whilst passive investors generated returns of 7.7%.
Yes, it can. Granted that active investments are costly and lower profit returns, and yet many investors still hold actively managed funds and have active managers. Despite all the drawbacks, several factors and circumstances have led to actively managed mutual funds and actively managed 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 vehicle over the long term. High-cost active funds do worse than passive funds because of their high fees. Global real estate funds generated 1.2% more in ROI than their passive competitors over the last decade. Large capitalisation value stocks outperformed index funds by 1.13% on average.
The study, however, is not conclusive, and there is research that suggests otherwise:
- Only 24% of all actively managed funds did better than their passive rivals over the last decade in the market index
- Active fund managers underperformed by 0.36% on average over the short-term, and their decline dragged on by 0.22% over five years
- Active investments yielded only 3.7% in profits, compared to 10% ROI in passively managed investments
The success or failure of active funds largely depends on the circumstances, costs, active manager skills, and type of fund. For example:
- In the first half of 2020, foreign stock funds had better performance than their passive counterparts, whereas US stock funds could not
- Active funds like intermediate core bonds, corporate bonds, and high-yield bonds generated better performance than passive investments
- In prolonged price declines (a bear market), active funds in commodities, alternative and sector equities had higher success than passive 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.
Can active investing beat the market?
Yes and no, depending on your goals. You may be able to beat the market, but you're more likely to do it by luck than by being smart. In the active stock market, you can invest in small-cap stocks issued by companies valued between 300 million and 2 billion euros 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 for investors than large-cap company stocks. However, small-cap company stocks are also more volatile, and therefore, investing here carries financial risk. If you are comfortable 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.
Are actively managed funds worth it? The answer varies. The majority of the time, active investments tend to underperform, and yet, no one has recommended dropping these funds. That is because the main purpose of active investment is not only to beat the market, but to manage the other aspects as well, such as minimising risks and tax management. Furthermore, some actively managed funds are also offered at a low cost, which have been shown to outperform passive investments with higher costs. Some examples of low-cost, actively managed investments are junk bonds, international real estate funds, international stock funds, and emerging markets.
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.