Should you be using active funds in your investment portfolio? Probably not.
But active funds are essential when it comes to investing. Without them, the great wealth making machine that is the global stock market, would not be possible.
Luckily, there is a way you can benefit from all that’s good about active funds without paying the high costs they charge.
Why we believe passive funds are better than active funds
When you want to build an investment portfolio it takes a lot of time and money to purchase stocks of lots of different individual companies.
Most people don’t have the resources, time, inclination or skill to do this so this is where investment funds come in.
A fund manager will allow you to invest your money with them and your money will then be pooled together with lots of other investor’s money. The fund manager will then buy hundreds of different stocks on your behalf.
There are two types of investment fund, active funds and passive funds.
An active fund manager believes they can beat the stock market. They will employ various researchers and analysts and try to identify individual stocks they think will grow more and faster than the market.
All this research costs money so active funds tend to charge a higher fee.
On the other hand, passive fund managers track a stock market. They will copy what the overall market does by buying and selling stocks in the same proportion as the stock market they are tracking.
As this approach doesn’t take much work, passive funds will charge a lower fee.
We tend to advocate using passive funds in your portfolio because this is what the evidence shows us is best.
Very few active funds outperform the market and even less do it consistently. Dimensional’s analysis of US active investment funds sums this up nicely.
Also, Nobel Prize-winning economist William Sharpe wrote a paper in 1991 called “The Arithmetic of Active Management” where he explains that the average active fund must underperform the average passive fund. It’s simple maths.
The market is made up of active funds, so every time one active fund buys a stock, another active fund is selling. So, it’s a zero-sum game. Therefore, the average active fund’s performance must equal the market return.
But then we need to take off the active fund’s fees from performance which will mean the average active fund is guaranteed to underperform the market.
Remember, passive funds track the market so deliver the market return. They still underperform the market because we must take off their fees however because their fees are much lower than active funds this means the average passive fund will beat the average active fund.
Why we need active funds
So, does all this expensive research that active funds carry out go to waste?
No, we as passive investors need active funds to carry out this research as it ensures the stock market is efficient and reflects fair prices for the stocks listed.
If we know that the price of the stock market is a reflection of all the analysis carried out by brilliant economists, scientists and analysts employed by active funds, then all we need to do is use passive funds to capture that price. Basically, piggy backing on all the work done by active funds, paying a fraction of the costs.
Want to find out more about an evidence-based approach to investing? Please give us a call for a free no obligation chat. We’d be happy to comment on your current investing strategy and how it compares to others in a similar position to you.
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.