Forget active or passive - this is what really matters when you buy a fund

Something I've been discussing a lot here recently is the "passive" versus "active" debate. More specifically, I've been arguing that the whole debate is badly framed.

There's no such thing as "passive" investing. We all have to decide where to put our money. We all have to come up with an investment plan (or get a financial advisor to help us do so). That's as "active" as it gets.

The question then is: once we know what we want to invest in, what tools do we use to implement that investment plan?

I was thinking about all of this again because this week I was at presentations by two of the best active managers in the business...

Two fantastic active funds

Nick Train from the Finsbury Growth and Income Trust, and Terry Smith of Fundsmith, were talking about their investment process.

Both Smith and Train have cracking records. I'd bet that a lot of you own their funds. And you'd be absolutely right to. I can always find something to complain about – fees can always be lower – but there's no arguing with either manager's performance.

From 2001, the Finsbury Growth and Income returned an average 9.7% a year, compared to 4.4% for the FTSE All Share. During that time, the fund outperformed the All Share in all but three calendar years.

Meanwhile, Smith's launch fund – the Fundsmith Equity Fund – has returned an impressive 18.2% a year (and that's after fees) since launch in 2011. That compares to 10% a year for the MSCI World Index (as measured in sterling).

Those are good returns, and they're a lot better than if you'd invested in "passive" funds tracking either Smith or Train's benchmark.

Does that mean that the returns will continue in the future? Nope. Past performance and all that.

Does it mean that everyone should invest in their funds? Again, no. It depends on what you're looking for.

But both of these managers nicely illustrate some key points you should be considering when you decide how to put your investment plan into action.

You can't always be in the hottest investment

One of the first things to understand about investing is that you can never be in the very best investment all the time. No one can. That's not an active fund manager's job.

So before you invest in any fund, you need to understand what it's doing. To give a stupid example, if you want pure exposure to Japanese stocks, there's no point on buying a FTSE All Share tracker, or a global equity income fund.

The nice thing about "passive" funds, is that their strategy is usually pretty obvious – it'll track the underlying market. So if you want exposure to the US stocks listed in the S&P 500, then buy an S&P 500 tracker. Simple.

Active funds are often trickier to wrap your head around. The manager will usually be aiming to outperform one index or another. But how do they plan to achieve that? Before you are willing to pay the premium to invest in an active fund, you should make sure that you understand this.

For example, both Nick Train and Terry Smith take what would broadly be described as "quality" approaches. They look for good companies that are likely to survive and prosper over the long run. In practice, that narrows their investment universe down significantly.

You're not going to find miners – no matter how good they are – in either of these managers' portfolios. Same goes for other cyclical businesses. What you'll find instead is companies with high-profile brands, predictable revenues, a loyal (or even captive) customer base, a long record of success, and – typically – not a lot of debt.

You'll also find that neither cares much about the "macro" – the "big picture"– stuff like currency movements and interest rates. Why would they? Their job is to invest in good companies for the long run. Those companies will have to survive all manner of economic backdrops in that time.

Neither Train nor Smith's approach will always be the best performing strategy. In some market conditions, their particular methods of investing will underperform others. Sometimes "trash" (cyclical stocks) beats quality.

And in other cases, it'll be nothing to do with their strategy – their particular market will just be out of favour. If emerging markets are taking a battering as they did earlier this year, well, then Smith's emerging equity fund is going to take a hit, regardless of how good a stockpicker he is.

But what they do offer is straightforward, transparent investment strategies (yet not so straightforward that you can easily buy a passive fund that will do the same thing). They also offer consistency and conviction – they aren't going to change their minds and switch strategy if next quarter's results aren't quite up to scratch.

And that really matters. Because as long as you understand what an active manager is aiming to do, and you can rely on their ability to execute on that strategy, you are then in a position to decide whether it's worth paying a premium for their services.

In this case, for example, it's clear that these managers do a good job of picking "quality" companies to invest in. It's also not the easiest strategy to replicate with a passive fund.

So your decision then boils down to: "Do I want a "quality" strategy as part of my portfolio? And if so, what proportion of my portfolio might that be?"

One key lesson to take away

That's not an easy decision either, of course. Maybe you think that quality is overpriced, and cyclicals (commodities for example), are the place to be just now, and you want your asset allocation to reflect that.

This is what I mean about "active" and "passive" being poor descriptions. You're always going to have to make some tough decisions about where you want your money to be – you always have to be "active".

I'll be writing a lot more about this over the next few weeks. But if you only take one thing away from this Money Morning, it should be: "Don't invest in any fund whose strategy you can't explain clearly in a sentence."