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Passive investing: Should you try to beat the market?

If you want to grow your money for the future, should you try to beat the market? The age-old active versus passive debate rages on and whilst there’s nothing wrong with trying to outperform a benchmark, the expensive fees often attached to active funds can eat into your returns.

There are two main investment strategies in the investment world; active and passive. Passive investments aim to replicate the returns of a benchmark by tracking the investments within it.

As active fund managers aim to outperform their benchmark, they look to take advantage of short-term trends and try to minimise the impact of a downturn. Trying to beat the market takes a lot of resource, and these costs are then passed onto the investor, which eat into their return.

Do expensive funds perform better?

Active fund managers don’t always get it right, with these funds often underperforming the benchmark they’re trying to beat. You don’t always get what you pay for, but in active wealth management, you’re still required to pay.

Whilst fees are a fact of life when you want someone to carry out a service for you – no matter the industry – the more you pay in fees, the less of your money you get to keep and the more your investments have to grow to break-even.

Funds charge an annual management fee, which covers the cost of running the fund and is where the asset manager tries to make its profit. Expressed as a percentage, this can vary wildly from fund to fund, and can reach as much as 2%.

The ongoing fund charge is a more accurate snapshot of how much a fund might cost you over 12 months, but it still doesn’t always reveal the full picture. On top of this, you’ll probably have to pay a platform fee which enables to you buy and sell the particular fund.

Be aware of any complex fee structures or surprise charges that can reduce your return even further. You might be charges the cost of your asset manager buying and selling investments, certain admin charges or platform costs from your provider, including an inactivity fee.

It’s crucial investors understand how fees impact performance. Whilst you can never guarantee a return from your investments, you can control how much you pay in fees.

ETF investing

Exchange Traded Funds (ETFs)  are passive investments that combine the low-cost nature of index trackers with the trading ease of a normal stock as they can be traded on the stock market. ETFs have surged in popularity as investors hunt out low-cost, simple and transparent alternatives to actively managed funds.

They are similar to a closed-end fund as they have a set number of units that can be bought and sold over the exchange, although these can be created or redeemed. ETFs also offer more transparency and generally don’t use leverage – unless specified.

ETFs are changing the face of asset management, as investors shift away from active funds.  ETFs attracted ten times the new capital that went to traditional funds in 2017. With $460 billion flooding into ETFs globally, this breaks down to $1.8 billion on every working day of last year*.  

With much of the money flowing to passive funds coming from the active management space, the stock-pickers are under pressure to lower their charges. According to Morningstar, the average net expense ratio of US equity mutual funds fell from 1.44% in 2000 to 1.13% last year. ETFs are saving investors money both directly and indirectly.

With some ETFs becoming too big for the index they track, the power passive investments now hold in the financial markets makes some big investors nervous.

Does active or passive investing perform better?

Of course it’s impossible to beat the market every year, yet active funds have been struggling. In 2016, two-thirds of large-cap active fund managers failed to beat the S&P 500, according to S&P Dow Jones Indices.

The smaller asset managers didn’t fare much better, with 90% of mid-cap and 86% of small-cap managers missing the mark.

This underperformance will have contributed to the record flows to passive funds in 2017 – the second longest bull market on record will also have helped.

Active fund managers in Europe have since pulled their socks up, and just over half of equity funds outperformed their benchmark in 2017, up from 23% in 2016, according to research firm Scope Analysis. The number of outperforming bond funds rose from 33% to 50%.

At Moneyfarm, we have nothing against active investments, but we do have a big problem with the fees investors are required for the privilege – or not, as history would suggest. Low cost investments mean investors can keep more of their money.

Of course, when it comes to passive investments, if the benchmark a fund is tracking falls in value, so will the fund – if it’s doing its job right.

Successful passive investors build portfolios that are diversified across asset classes and geographies to manage this risk. Diversification looks to offset any losses in your portfolio with gains made elsewhere.

Whether you’re deciding which fund to invest in, how to build your portfolio, or whether to invest at all, all investing carries some active decision making, whether you’re using passive instruments or not.

The right portfolio reflects your investor profile and tolerance to risk through the allocation of assets within in it. This can be difficult to get right yourself, but understanding this relationship is one of the first steps to growing your money for your future self.

You can find out what type of investor you are for free with Moneyfarm.

* 05/02/2019, Financial Times

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