Investing in Funds: First Principles

Finally, we need to know something about the difference between 'active' and 'passive' funds.

A common characteristic of what are sometimes known as 'traditional investment strategies' is benchmarking. Benchmarking simply means comparing the performance of an investment - whether a portfolio of direct investments, an investment fund, or a fund of funds - against a relevant market (usually represented by a market index). Note that traditional investment strategies can be contrasted with 'alternative investment strategies' which pursue absolute returns rather than a return relative to a market benchmark.

Actively managed funds try to beat the market's average performance. Passively managed funds -often known as tracker funds - try to replicate the market's average performance.

Sounds a bid odd doesn't it. After all, if one fund manager tells you he is going to try and beat the performance of an index and another tells you he is simply going to try and match its performance, you would choose the first manager wouldn't you? Not necessarily.

Fund managers - like private investors - find it very hard to beat the market. Why?

The problem

The more diversified an investment portfolio is, the nearer the market average its returns are going to be.

In this sense, to actually beat the market average you need to actively embrace a higher element of risk; taking on stock or sector specific risk to get the higher returns. But this is a very hard thing to do on a consistent basis because, by definition, these stocks or sectors are going to have much more variable returns.

And fund managers trying to outperform the market have another problem too. In one respect they are going to find it even harder to outperform the market than the ordinary investor is. Funds, especially the bigger ones, hold so many stocks that - even where they are looking for high returns - they are often too diversified to stand a good chance of getting them.

So why don't they just make themselves less diversified? Well, it is not that easy, because funds with a lot of money to invest cannot concentrate it all in five or six companies or they would end up owning all the shares (they would end up owning the companies).

The solution?

Passive investment strategies are a response to these stark truths. But it is a bit of a misnomer to call them passive at all, because building and managing a portfolio that accurately tracks a market index involves a lot of hard work - particularly in making sure that the fund accurately replicates any changes in the composition of the index being tracked.

To do it, passive managers use a range of different mathematical techniques - full replication, stratified sampling, optimisation and so on. You don't have to know about any of them. All you need to know is that a passive fund manager needs to be fully invested in indexed stocks at all times and those stocks need to be held regardless of their individual prospects.

Passive management now represents a significant proportion of the institutional investment market - as of November 2000, around 30% of the US market and 20% of the UK market. In other parts of the world indexation is less established as it is felt to work best in 'efficient', developed markets.

So is a passive fund management approach a better bet for the individual investor? Recent research in this area conducted by the WM Company reached the following conclusions:

On average, active management underperforms passive management after costs.
This is not the same as saying that active management cannot provide superior returns or that some investors do not benefit from it.
The key question is whether active managers can demonstrate an ability to consistently outperform a given index and/or the majority of the competition.
A further question is whether such 'skill' can be identified and accessed by investors. If it can, some investors may achieve highly satisfactory returns from choosing an active manager.
In essence, investors have to weigh up the chances of identifying an outperforming active manager in advance against the relative certainty of the returns provided by a tracker fund.