INDEX INVESTING ACTIVE AND PASSIVE IN A SINGLE PORTFOLIO
Asset class returns – discrete years
Source: Seven Investment Management
“
A US academic
study looked at the
performance of 1,446
US active funds,
tracking the S&P 500
index over a ten-year
period, and found
that only 35 funds
outperformed. An
investor’s chance of
having one of these
35 funds is one in 42,
which is worse than
the odds you get at
a casino’s roulette
table
”
evaluated on a qualitative
basis.
Needless to say, when it
comes to fund selection,
there are advantages and
disadvantages to either an
active or a passive
approach. Many private
investors are more comfortable
with active funds
that are managed by real
people that they can communicate
with if need be
and who may outperform
over time. Indeed, the
present volatile market
environment may provide
scope for active managers
to outperform principally
because they have the ability
to hold cash in the
downturn.
l Underperformance
However, most research
points out that over the
long term active portfolio
managers as a whole tend
to underperform their
chosen benchmarks by
around 2% a year. This is
due to the cost of their fees
and due to the dealing
costs. Many investors have
become disgruntled with
this level of underperformance
and have elected to
buy passive investments
designed to follow a given
index at minimal cost.
There are even different
types of passive fund, from
trackers with Legal &
General or Vanguard to
exchange-traded funds
(ETFs) from iShares or
Lyxor. As there is little or
no judgement involved
with this type of investment,
there is no chance of
outperforming the index
and any investment in a
passive fund will enjoy the
full rollercoaster ride of the
underlying index.
This 2% cost a year may
not sound like a lot, but
over ten years it is the difference
between your
investments rising by 63%
at 5% a year or nearly doubling
(up 97%), if earning
7% per year. The difference
is significant and
demonstrates the power of
compounding.
l The perfect blend
A US academic study
looked at the performance
of 1,446 US active funds,
tracking the S&P 500 index
over a ten-year period, and
found that only 35 funds
outperformed.
An investor’s chance of
having one of these 35
funds is one in 42, which is
worse than the odds you
get at a casino’s roulette
table.
This is surely a very
good argument to find low
cost, passive investment
funds rather than trying to
find the 42nd lucky fund
manager. This is why we
use a wide selection of
passive funds investing
across global equities,
bonds and alternative
assets. The equity, bond
and alternatives we buy
are selected on the basis of
their anticipated returns
and how well they blend
together to diversify risk.
In general, when looking
at how to blend the
different passive funds
together, ETFs tend to be
more liquid and versatile
than tracker funds, but
have the downside of
being slightly more complex
and slightly more
expensive.
Alongside the everpresent
counterparty risk,
cost is clearly an important
factor in selecting passive
funds. The up-front costs
of purchasing is a consideration,
with some tracker
funds charging an initial
4% and other funds charging
zero. Annual total
expense ratios must also
36 PORTFOLIO ADVISER [www.portfolio-adviser.com] JANUARY 2010
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