Should I invest actively or passively?
02 June 2017 | Portfolio construction
Actively managed funds tend to cost more, but they have the potential to deliver better returns. So when should investors choose active, and when should they choose lower-cost passive?
James Blake (head of editorial, Vanguard UK): Should I invest actively or passively? How do you decide whether to invest actively or passively or both? Well, to help us think about this question, I want to talk about the investment return that you see, and there are three elements to that.
The first is the market return. The second is any additional return that the fund manager gives you, and the third is costs.
A passive investment is aiming to give you a return as close as possible to the market. The manager is not trying to influence that return at all, so that element will be close to zero. And the costs with a passive fund are normally relatively modest. So with passive investment, your return will be roughly the market return minus some modest costs.
An active fund is different. The market return will still be a big component of what you see, but here the manager is actively trying to influence performance. So this element will be a much bigger component. And costs will typically be a bit higher than they are for passive funds. So with an active fund, your return is the market return plus or minus the manager return minus some costs.
So as you can see, there's a few layers of uncertainty going on here. You don't know what the market return will be. It could be positive; it could be negative. And on top of this, with an active manager you don't know whether they will succeed in delivering additional performance or whether they will fail. And in reality sometimes they will be successful and sometimes they won't. So you need the patience to endure those inevitable periods of underperformance.
With a passive fund, you know that your return is going to be much closer to that of the market. So when you're deciding between active and passive, that decision is going to be influenced by your appetite for uncertainty. And, of course, it's not a binary decision; you can combine the two. Maybe you've found an active manager that you have a high degree of confidence in and so decide to put some of your money with them and then you leave the rest of it in passive. It's up to you.
But whatever route you take, the one thing you do know is that costs will eat into your returns, so make sure you minimise costs because that way you get to keep more of your investment return.
Thanks for watching.
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