When you invest in a fund, you have two basic choices. You can go active. Or you can go passive.
Active funds are expensive. Passive funds are cheap.
Why are active funds expensive? Because they are meant to beat the market.
That's why you pay more for them.
Passive funds just try to track the market, using an automated process. That's why you pay less for them.
Here's the snag. The vast majority of active funds don't beat the market. So most of the time, you're paying for a service that you don't get. As a result, logic suggests that most investors could do better by investing in 'passive' funds which are cheaper, and which merely promise to track the index.
Any objections to that premise? Well, the industry has a go in the FT this morning. But they utterly fail to address the key problem at the heart of all this.
The real problem with active management – the price
There's a good piece in the FT today from Madison Marriage. It follows up on her discussion of the woeful performance of active managers, as shown in the latest S&P Dow Jones passive vs active scorecard.
Those figures demonstrated – not for the first time – just how badly active fund managers do compared to their benchmarks.
Well, they don't deny it. Instead, the solution – they say – is for private investors to work harder at finding decent active managers.
Um. OK. That sounds like a great idea. Let me just take a break from picking through the grains of sand on this beach, hunting for the single gold flake I've been told is definitely in here somewhere, so that I can track down a decent fund manager.
Or – here's an idea – why don't I just stick my money in a cheap passive fund instead of sifting an entire industry for the handful of people who can actually do the job I'm paying them to do?
Good grief! It's harder than finding a reliable plumber. Though not as messy.
Unsurprisingly enough, none of the active fund managers mentioned in the piece highlight the biggest problem: their fees.
Your average active fund charges about 1.5% a year. Passive funds average 0.6%, according to Deloitte, but in all honesty, that sounds high to me. You can get passive trackers on mainstream indices for far, far less than that.
So active managers are handicapped from the off.
There is only one certainty in this argument. Those managers would find it easier to beat their benchmarks if they charged less for their services.
The truth is, if an active fund manager is doing their job correctly, then the job shouldn't involve that much "busy" work. You choose a strategy. You find a decent selection of companies or investments that fit the bill – you already know that anything more than 20 doesn't add much to performance, so why have a lot more than that?
Having picked your favoured investments, you sit on them, topping up as and when necessary. You keep an eye on the results. Every so often you rebalance the portfolio.
I'm not saying it's easy. But there's no need to be at it 60 hours a week either. You could make a perfectly decent living at this while charging a lot less, or charging a flat fee.
The good news on the active management front is that increased competition and awareness from investors is driving more competition here.
Active managers are experimenting with new fee structures (in fact, Merryn recently interviewed one manager who she reckons may have come up with the "perfect" fee structure – see the piece here).
Meanwhile, furore over "closet trackers" (active funds which basically do nothing more than copy passive ones) is putting pressure on active managers to live up to their name and run more concentrated portfolios and take more specific bets.
However, change is happening at a glacial pace. So as we already said, unless you're willing to do your homework and take a more active interest in your investments yourself, you are better sticking with passive funds.
(Alternatively, you should look at investment trusts. These generally have a better track record and we're very keen on them. However, I'll deal with these in another Money Morning – running out of space this morning.)
Forget passive vs active – let's call it cheap vs expensive
Of course, none of this helps with the question of asset allocation. This is where – as I've said before – the notion of "passive" vs "active" is incredibly unhelpful.
Every investment decision you make is 'active'. You could split your portfolio five ways between Japan, the US, the UK, high-yield bonds and cash. Or you could split between gold, Vietnamese equities, US index-linked Treasuries and seven other asset types. Or you could lump the lot into a buy-to-let in Basingstoke. (Needless to say, none of these represents a recommendation on may part...)
In virtually every case, you could choose either an 'active' or a 'passive' fund to invest in each of those asset classes (well, except the buy-to-let). But every single one of those portfolios represents an awful lot of "active" allocation on your part.
So maybe we should stop using the terms active' and "passive". Maybe "expensive" and "cheap" would clarify the difference. Is it worth paying up for the "expensive" option? If it offers good value and something that you can't get from the "cheap" route, then yes. Otherwise, stick with the "cheap" option.
By the way, if you're a long-term investor looking for help with the asset allocation side of things, then we have the ideal strategy for you to take a look at – here it is.