There are few issues more contentious in the investment world than the debate about whether passive or active investing is better. Most wealth management firms and investors tend to prefer one of the two strategies, with passive investments in fashion because their management fees are perceived to be low. In this series of articles, we’ll explore the role of these strategies in an optimal investment portfolio as well as the pros and cons of each.
Passive funds simply try to replicate the performance of an index, such as the Dow Jones Industrial Index, the FTSE 100 or the JSE All Shares Index. They are strongly associated with Exchange Traded Funds (ETFs), which are marketable securities that track an index, a commodity, bonds, or a basket of assets like an index fund.
Active funds take a stock-picking approach, aiming to select the top-performing assets with a view to delivering better returns than the market. Their drawbacks are well understood, including higher fund management fees and the inability, on average, to outperform the market.
However, there are many disadvantages to passive funds that investors may be overlooking. Here are some of them.
- Passive funds are guaranteed to underperform the index after costs, which means that one cannot expect better or as good returns than the benchmark delivers.
- Passive funds are not as cheap as you may think they are and could be as expensive as a fund manager when all costs are taken into account. They have many hidden costs, including brokerage fees and taxes. Some of the most vociferous passive fund managers publish performance figures gross of fees and expenses, which means that these costs aren’t transparent, despite their emphasis on costs.
- Fund managers in charge of passive funds may not be able to replicate the index they are tracking with 100% accuracy because of sampling errors.
- With a passive fund, investors’ new proceeds are forced to purchase the shares that already make up the index – many of which may be expensive or even overvalued – limiting the upside potential.
- Passive funds are not completely passive and can attract large transaction costs as they need to constantly buy and sell assets to remain aligned with the composition of the index they track.
- Passive funds do not anticipate changes in economic cycles until it is too late. When the market falls, so will the passive fund.
- Passive funds do not offer risk management – for example, a passive fund will be tech-heavy at a time when technology stocks are outperforming the rest of the market. This makes them largely more volatile than active portfolios.
- Shares in a passive fund may be overvalued simply because they’re included in an index, which forces fund managers to buy them regardless of their return prospects.
- Investors in passive funds might become complacent because they believe the index is always right. They could instead take an approach that hedges them from some of the risks in the market.
Despite all of the above, we believe that passive funds still have an important role to play in a well-managed portfolio, and our investment philosophy incorporates the use of active and only the most efficient passive approaches. However, the ideological devotion they attract from their strongest advocates does mean that many investors are not looking closely enough at their risks and drawbacks.
Just like the active fund managers, passive fund managers are seeking to sell a product, which means that one should look beyond the marketing before committing money to them.
In part two of this series, we look at the benefits of passive funds and why they are an important building block in a well-managed portfolio, despite the disadvantages I discussed in this article.