In the investment world, you might have heard the terms active management and passive management. If you’ve been hit by the marketing, you may think that passive is better.

But is that really true?

As with most things in life, the answer is maybe.

Active fund management is where you give your money to your local investment manager. They have teams of investment analysts who scour the market and pick stocks for their funds.

When you listen to their marketing, they often portray themselves as having oracle-like abilities to pick the best stocks. They appear to be prophets of profit.

The problem with active management is that despite all that stock-picking ability, these prophets of profit often fail to match the benchmark that they measure themselves against. Even if they do manage to beat the benchmark, after they take their fees, most active fund managers fall below the benchmark.

Then came John Bogle.

The late John Bogle was the founder of the Vanguard Group and he is credited with popularising passive investing. The Vanguard Group is the market leader in passive investing and is an investment giant with close to $9.3 trillion under management.

Passive investing starts with an index.

An index is a financial term for a group of stocks. Perhaps the most famous index in the world is the S&P500. It is a group of the 500 largest companies listed on stock exchanges in the United States (actually it has 503 companies, but let’s not split hairs).

Passive investing works by buying the stocks in an index, in proportion to the value of the companies (i.e. market capitalisation). Passive investing is much cheaper than active investing because you don’t need a team of highly paid analysts to pick stocks, you just follow the index.

Since passive fees are really small, the passive fund delivers almost the same return as the index that it tracks. That means passive funds beat the returns of most active fund managers.

As a result of that, for the past few decades, most investments have been flowing in to passive funds as opposed to active funds. This trend hit a milestone in December 2023 in the US, where total assets under management in exchange traded funds (ETFs) and passive mutual funds hit $13.29 trillion. For the first time in history, passive funds assets exceeded the $13.23 trillion in active funds.

The problem with passive

While passive funds are great from a cost point of view, they do create a problem. The bigger a company is in an index, the more of its stock has to be bought by each passive fund. That creates a reinforcing effect where companies with large market values tend to remain large and get more expensive as more passive funds buy their stock. Conversely small companies that are not part of the index get ignored.

So the stock market as a whole gets less efficient. Big companies mindlessly get bigger and small companies get ignored.

Closet indexers

The quickest way for an active fund manager to lose their job (or their large bonus) is for them to underperform their benchmark. When that happens, clients withdraw their money and move it to passive funds.

So many active funds become closet indexers (or market huggers as I like to call them). Closet indexers create an active fund that closely mimics the index. The do this by breaking down the index into the various industries (e.g. semiconductors, healthcare, automobiles, etc). Then they buy most, if not all, the companies in those industries. But they buy them in different proportions to that of the index. If the companies they bought more of do better, their active fund outperforms the passive benchmark. If not, they underperform the benchmark - but not by much. As long as these fund managers are not too far below the index, their jobs are safe. 

And you get the honour of paying to save their jobs because you pay active management fees instead of lower passive management fees. Passive funds have fees below 0.5% per annum, whereas active funds can have fees between 1% and 3% per annum. Some active fund managers and hedge funds will charge a basic fee and have a performance fee for when they beat the index.

Smarty-pants active fund managers

Then you get the smarty-pants fund managers who try not to mimic the index. To keep their fees nice and healthy, they simply change the benchmark against which they measure their performance.

They measure against custom benchmarks, which inevitably are lower performers than a broad index like the S&P500. That way they can charge you active management fees and they can charge a performance fee when they beat the new lower benchmark.

Like the kid in our example, they want a reward for beating the average, even if the average was a fail.

A few years ago, in my neck of the woods, the largest active fund manager changed their benchmark from a market index to the average return of local equity funds.

If most active fund managers underperform the index, then average return of local equity funds is likely to be lower than that of an index. Furthermore, in a down year, the average return of equity funds could be negative. 

Then they back-tested the new fee structure and told clients that their fees would be lower than before.

This boggles the mind. They charge a fixed fee and a performance fee. They lowered their performance benchmark, making it easier to achieve, and yet they claim that their fees will be lower.

Perhaps they weren’t lying, but one wonders whether the time period selected to back-test the fees was carefully chosen to support the case for the new fee structure.

Smarty-pants passive fund managers

Just when you think it couldn’t get any worse, some passive fund managers are becoming smarty-pants too.

The majority of exchange traded funds (ETFs) are passive funds. These are investment funds that you can buy on the stock exchange like a share. They are usually listed on the stock exchange by passive fund managers.

But now some passive fund managers (and others) are introducing active ETFs onto stock exchanges. These active ETFs charge fixed fees and performance fees. So be wary, not every ETF is passive and low cost anymore.

The dilemma

As an investor, I am mindful of the fact that a market full of passive funds will be inefficient and very risky to investors. We all understand the need for active management – we cannot buy all our stocks mindlessly. But active management is expensive.

The solution

Individually, we cannot all spend our time picking stocks and we cannot do it as cheaply as large fund managers, who have scale. We want the low fees of passive management, but we also want some active management.

The solution is a combination. I have mentioned the core-satellite portfolio before (here). The basic principle is to have the core of your portfolio be a low-cost index fund or ETF. Then you add performance by choosing active funds or stocks as the satellite portion.

A couple of points when implementing this. Firstly, you don’t have to use one low-cost index fund. You can choose a few.

• The S&P500 is a good US index.

• The MSCI World Index is a broad world index with about 1400 companies.

• If you like tech, the Nasdaq 100 is made up of the 100 largest non-financial companies on the Nasdaq.

Secondly, for the satellite portion you can pick stocks yourself – but this is not practical for most people. So, the next best thing is to choose well run active funds.

Characteristics of a well-run fund

With an active fund, you’re looking for a fund that has a fixed fee only (no performance fee). The days of performance fees are largely gone in fund management. The market is too competitive. But there are still fund managers charging performance fees. Be wary of them. They are hanging onto the past.

The next thing you’re looking for is that the fund manager (and preferably the founders) have a large chunk of their net worth in the fund. That is the only way to guarantee alignment. When the fund loses money, they should feel the pain. If the fund gains, they can enjoy it with you. 

Finally (and this is the hardest part), you should invest with fund managers whose investment philosophy you understand. I’m saying know what you’re investing in. The fund manager should be clearly and simply articulating what they do and how they do it. If it sounds like they are stock market oracles or prophets of profit - beware!

Before you invest, read the fund fact sheet - it’s one or two pages long. It is not overwhelming. Listen to the fund manager presentations - you can find them on their websites or YouTube.

Conclusion

It’s your money.

Find out how it is being invested and how much you’re paying for that service.

If you’re a busy person, hire a reputable financial advisor and get advice.

I would like to hear what you’re up to.

DM me on social media or email me.