Active Vs Passive funds – Is there a right and wrong?

The recent comments from Michael Burry, the hedge fund manager from The Big Short, about the increasing risks of passive investing, somewhat reinforces the advice we’ve been giving to our clients in recent years. His words have been echoed in the last few months by a number of revered investment gurus.

In the past few years, we’ve observed a worrying trend among everyday investors, who are increasingly falling victim to a heuristic approach to passive investing, applying little more than a rule of thumb based on historic data. Rather like the crypto-currency fever, investors have watched colleagues, friends and families raking in profits with ETFs and index-fund laden portfolios, during what became the longest bull run in history, which saw the S&P 500 leap 250% in 10 years. Even cynical investors who were standoffish in the initial few years of the bull run, by year 7 or 8, were clambering onto the Passive Express as it chugged cavalierly towards the next summit, mirroring record highs as seen from the likes of the S&P and Dow Jones.

Those who joined the party too late have been watching their portfolios yoyo between Tweets from Trump and rebuttals from China. The waters are choppy, and we see no sign of there being a prolonged period of calm. The Dow Jones hit a record 27,359 points on 15th July 2019, and has since bobbed up and down. In Europe, the DAX hit a peak of 13,559 on 23rd January 2019, and is struggling to surpass this peak 18 months later. Investor edginess is now seeing many passive investors selling out of their funds at a loss, often unsure as to where to redirect their money in the face of evident global deceleration.

While any financial adviser worth their salt would be careless to dismiss the admirable attributes of index funds or ETFs, as financial advisers guiding clients towards medium and long-term investment goals, ensuring a degree of asset preservation is as important as nurturing portfolio growth.

Our primary concern with investors seeking passive funds, is that there’s a notion that somehow introducing active funds will contaminate their portfolios and erode growth. While it’s true that these funds typically carry higher costs, this becomes largely inconsequential when a fund manager is able to apply the brakes on a fund diving into an abyss, while a passive fund may hit the ocean bed and languish there for days or weeks. Ironically, copycat passive or “lazy” investing is becoming an extreme form of timing the market, looking at past performance and making an assumption that this will be repeated in the future, passively. Whereas, time IN the market with a balanced portfolio of both active and passive funds has allowed many a portfolio a fighting chance of recovery in the face of a flash crash.

The ETF industry has exploded with USD trillions invested globally. Due to expense ratios as low as 0.1%, they must attract enormous volume running into billions of dollars to realise a profit, and to continue their run. In a market that experts are now warning is overpriced, the fatigue we are now witnessing across passive investments is of no great surprise. At the same time, the traditional 60/40 equity/bond ratio is now being questioned, most recently the Bank of America declaring the formula dead. Fund managers will not only look to soften a fall, but will also observe traditional formulae objectively, relying more on analytics, which often helps to maintain buoyancy in the overall portfolio.

Our advice to clients to hold a balanced portfolio of mixed funds predates the bull run and continues after its conclusion, as a result of which much of our client base are seeing steady accumulation of their savings towards their objectives. While history has proved that investing £1000 in the FTSE 1000 in 1984 would have seen that money increase 7 fold by now, savings goals nowadays increasingly encompass short to medium-term goals, where we must aim to protect downturns if we need to cash out after 7 to 10 years.

We are now rolling out model portfolios and DFM arrangements to support this stance, cementing our belief further in the benefits of holding diversified funds from both the active and passive camps. Despite the tremendous gains in the indices recently, our position remains unchanged. Yes, we are fans of index-linked funds and they have a strong presence on our preferred fund list. During a market rally, they are often the star players. However, now having had our lives turned upside down by Covid 19, and with a volatile outlook for some time, we find ourselves in a landscape fraught with regular peaks as well as unexpected troughs. These ingredients provide the perfect recipe for active fund managers to apply their skills, with the ability to harpoon the peaks and then lay a bridge across the ravines, where active funds offer no safety net.

Leave a Reply

Your email address will not be published. Required fields are marked *