Lowes Magazine Issue 118

DOUG’S DIGEST

Passive or Active investment?

WITH THE MOVE IN RECENT YEARS TO GREATER transparency when it comes to costs, and also the proliferation of online “self-select” investment services, there has been greater focus given to passive investment funds, which, due to the automated nature of the investment processes, can operate at a much reduced cost. Care must be taken, however, to make sure that our investment choices offer the best long-term prospects, and not just the cheapest. Passive investments try to replicate the performance of a given stockmarket index or benchmark, such as the FTSE 100 index, including the reinvestment of any dividends generated by the underlying companies, but without making any decisions about whether or not the underlying companies are worth investing in. These should not be confused with structured products which, whilst often linked to the likes of the FTSE 100 index offer pre- defined returns and protection based on the position of the defined underlying index and have pre-defined maturity dates. Active investments, on the other hand, are managed by a single person, or a team of people, whose job it is make decisions about which companies within their available universe are worth investing in. So, sticking with the FTSE 100 as our example, they may only choose 30 or 40 of those companies to hold within their portfolio, discarding the rest. People often believe this means a passive fund diversifies the risk by investing across all the companies available, but as the FTSE 100 is a capital weighted index (i.e. each company does not contribute an equal amount, but instead the larger the company the bigger its contribution) the top ten companies account for over 42% of the index, and so the same concentration in the passive fund. The same applies to the sector breakdown: there are 19 sectors within the FTSE 100, but the top five account for nearly half of the index. This is fine when the biggest companies or the biggest sectors are doing well, but when they are falling, or even just in the doldrums, a passive investment will continue to track their performance, whilst an active manager can move on to a different company with greater potential.

Of course, if the manager were to pick the wrong companies, or get his timing wrong, then this will lead to poor performance compared to their benchmark or sector. It is rare for any fund manager to never make a wrong decision, or to never have a poor period if the portfolio they are confident in for the long term proves unpopular in the short term. With proper research, however, it is possible to avoid the poorer fund managers in the main, investing instead in those who are more likely to consistently outperform The main argument used against active investment funds is of course the cost, as mentioned in the opening paragraph. A popular fund which tracks the total performance of the FTSE All Share index is currently available with an ongoing charge figure of just 0.06%, which compares very favourably with an actively managed fund which would typically have an ongoing charge of between 0.8% and 1%. As with most things in life, however, cheap does not necessarily equate to value for money. With an investment this comes down to the performance – if you invest £10,000 today, how much will it be worth in 10 years? This is the main reason we favour active funds over passive funds. It is illustrated by the illustrated by the following chart. over the longer term. Worth the cost?

£35,000

£30,000

Active Fund Passive Fund

£25,000

£20,000

£15,000

Investment Value

£10,000

£5,000 Apr 11 Apr 12 Apr 13 Apr 14 Apr 15 Apr 16 Apr 17 Apr 18 Apr 19 Apr 20 Apr 21

Source: FE Analytics. Bid-Bid (after fund charges). Net Income Reinvested

Company

Weight 6.48%

Sector Weight Basic Resources 10.34% Industrial Goods & Services 9.98% Personal Care Drug and Grocery Stores 9.79% Health Care 9.74% Banks 9.49%

According to FE Analytics, £10,000 invested ten years ago in the FTSE All Share tracker fund, mentioned above, would be worth £18,018 today. Investing that £10,000 into a well-known mainstream actively managed fund, however, where the manager was picking companies from the same pool, would have given you a value today of £30,837, even after charges had been taken into account. That would leave the investor £12,819 better off, which is why we are investing, after all. As with all things, passive investing is evolving, especially with the application of technology. Where originally they only tracked the main indices, passive funds can now be found which track investment sectors, themes and factors through the use of rule- based algorithms, which are developments we are monitoring closely. There are occasions where a passive fund will be suitable, but it is important that the decision to invest this way is taken for the right reasons after appropriate research has been completed, and not just because it the cheapest option.

Unilever

Royal Dutch Shell (A & B)

5.80%

AstraZeneca

5.58%

HSBC Holdings 4.48% GlaxoSmithKline 3.84% Diageo 3.83% British American Tobacco 3.59% Rio Tinto 3.45% BP 2.93% Reckitt Benckiser 2.40%

Source: FTSE Group. Weightings as at 31st March 2021

Source: FTSE Group. Weightings as at 31st December 2020

Lowes Financial Management is authorised and regulated by the Financial Conduct Authority. Visit: www.Lowes.co.uk | Call: 0191 281 8811 | Email: enquiry@Lowes.co.uk