Passive compared with active fund management

There was an April Fool’s Day story going round financial markets to the effect that our regulators would be requiring those advisers who do not give “whole of market” advice to wear red, while IFAs would have to wear neutral colours.

Red tie and braces – for warning?

This joke hides an important message. It is important that changes to the way financial services operate being brought about by the Financial Services Authority’s Retail Distribution Review do not result in confusion about where consumers can get truly independent advice.

The importance about IFAs is that, however they are remunerated – by fees or commission – they are there to work for you, not to achieve sales targets for an insurance company or investment house.

How does this tie in with the way funds are managed?
There is, of course, no direct link. However, looking after your investments is something that needs to be taken very seriously, because the difference between the best and worst performing funds can be massive. So it is good to know that your adviser is working on your behalf.

It is also important, however, to ensure that you are happy with the investment strategy adopted by the fund manager with whom your money is left. After all, if they get it wrong, you could lose part or all of your money; or just make less than if you had selected an alternative fund manager. This is part of the skill of a professional investment adviser; to help you select a fund management company that is likely to perform best within the constraints of the level of risk you are prepared to accept and the method of investment adopted.

Three types of investment approach
Active management – Most investment fund managers have traditionally adopted an active investment management strategy. This means that, within the overall aims of the fund – perhaps to invest geographically in the UK, Europe, US, Far East, or by market sector such as technology, emerging markets, banks or so on – the fund manager will use his skill to try to out-perform competitors. This might be based on superior market knowledge, better contacts or simply more sophisticated financial modelling techniques.

Active management takes time and skill

Passive management – Some commentators have argued that markets are fundamentally efficient and that it is impossible for any one fund manager to hold better information than his competitors, so that it is better to follow individual markets and avoid the input of investment managers.

To meet this need, index funds were launched. These invest in the shares that make up individual indices such as the FTSE100, FTSE250 or Dow Jones. In some cases, only some shares are held and the balance of the tracking performance provided by derivatives – that is financial arrangements that allow the fund to track the index without having the cost of dealing in all the shares involved. These savings can be passed on to the investor in the form of lower management fees.

A half way house – One of the issues with tracker funds is that the indices change every few months with new companies coming in and old ones falling out. This can have a massive impact, because tracker funds have to buy and sell shares as soon as they join or leave. However, this instantly affects their price: selling the shares of a business that has left the FTSE100, for example, will reduce the price even more, and the reverse is true for new joiners – the price will rise further simply because of demand.

To counter this, some investment managers have developed index funds which adopt a strategy that largely reflects the composition of an index, but allows them to anticipate expected arrivals and departures. In this way, they can buy shares that are likely to enter the index before traditional tracker funds have to buy them and thereby push the price up further. They can also sell shares before other funds have to off-load them, further depressing their value. This involves additional skills amongst the fund managers, and costs will usually be higher than for a completely passively managed fund.

Are there any other options?
For the sake of completeness, it is worth mentioning that there are also funds of funds, where an additional layer of experts assesses the performance of individual fund managers, in order to determine whether they should be included in or removed from an ‘umbrella’ fund.

This all brings us back to our starting point that it is important always to take professional advice before making any decision relating to your personal finances. As ever, the value of investments is not guaranteed and will fluctuate; you may get back less than you put in.

NOTHING CONTAINED IN THE ARTICLE SHOULD BE CONSIDERED AS GIVING INDIVIDUAL FINANCIAL ADVICE. PLEASE NOTE THAT THERE MAY BE VARIATIONS FOR THOSE LIVING IN SCOTLAND AND NORTHERN IRELAND. 

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