Active vs Passive Fund Management

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When you look to invest in financial securities, stocks or bonds for example, you may think about putting your capital in managed funds. Managed funds are investments that consist of a pooled assortment of different securities, so that the risk is reduced substantially than owning a single asset holding.

Investing enables exposure to a wide variety of markets and sectors, but wherever you choose to invest, the fund manager over seeing your portfolio will likely take one of two basic approaches to manage your money: Active or Passive investing.

The aim of an active managed fund is to beat the return on investment of a particular market index, or some other defined benchmark. Fund managers seek to do this by using their knowledge of the market and their ‘feel’ to analyse investment opportunities. They will buy holdings of assets they deem undervalued, and so have the potential to increase in price. With active management comes with two basic approaches: top-down or bottom-up. A top-down approach consists of studying the broad market trends to predict which geographic or industry sector will prosper, only then do they research individual companies, to find which offer the best value in their sector. Whereas, bottom-up approach starts by analysing individual companies, where strong performance and potential is reflected on the current share price which is usually deemed undervalued to be assessed as a potential investment possibility.

The benefits to active management include the opportunity for outperformance, generating higher returns than the market average. However, professional market research that is needed for active management will drive up management costs, which means active managers can charge higher fees. They can also have higher operational expenses such as transactions fees and taxes, due to the higher frequency of buying and selling asset classes.

Passive management advocates on the other hand believe it is difficult to beat the market index (collection of assets chosen to represent a particular part of the market), so as a hedge they would rather attempt to match the performance of a market index, such as the FTSE 100, or a certain benchmark as a whole. This is why passive investments are commonly called index funds. The advantage of this strategy is to spread risk widely within a market, avoiding possible losses that could follow dramatic declines in any one asset class. However, risk is spread out but not avoided as the passive approach cannot protect against broad market declines as it follows the market. Passive investments also keeps the management costs low as research costs are avoided and securities are bought and sold less more frequently.

With passive management the main benefit is diversification which is paramount as having a well-diversified portfolio is essential part of a successful investment plan, and ‘indexing’ can be an ideal way to achieve diversification. However, as index funds track the entire market, when the overall market falls, so does the index fund. Another benefit is the low costs of investing in passive funds, as resources aren’t being spent on finding market winners, but then again, passive fund managers are usually prohibited in liquidating the fund they manage when they might anticipate a decline in the market index, meaning a lack of flexibility of avoiding downsize risk is present. Lastly, an index fund provides an easy way to invest in a chosen market that simply wants to mimic its performance which elevates the time and effort spent selecting and monitoring a specialist active fund manager.