In the seemingly interminable debate about whether it makes sense to pay for “active” fund management or “passively” to track markets more cheaply, a new report suggests no clear victory for one side but guides investors on when to choose one approach over the other.

A new report from Cheshire-based Equilibrium Asset Management examines seven UK unit trust sectors over 12 months, finding that active funds add value over index trackers in many parts of the market; however, in other areas, passive funds performed best. (The survey is called Active Vs Passive Analysis - Detailed Analysis of Active and Passive Investment Funds in the UK.)

While many in the industry have been in favour of purely active or passive funds, Equilibrium’s research “considers each equity sector in isolation,” the survey said.  

“There is much debate in the industry on whether we should take a passive or active approach to investment. We started this research for internal purposes to assist us in the selection of investments for our clients, but we soon realised the results have implications for anyone who invests in UK investment funds,” said Mike Deverell, investment manager at Equilibrium.

The issue is a vexed one because in relatively efficient, liquid markets such as the US S&P 500 index of blue-chip stocks, it is considered hard for a fund manager to consistently deliver market-beating returns year over year, and once fees are deducted, it is considered impossible for more than a minority of funds to give outsize gains to clients over time. On the other hand, in illiquid or hard-to-research markets such as some emerging and “frontier” markets, active management is seen as offering value for money.

Areas of interest

The research identifies three primary areas of investor interest: “Fund charges, the sectors they are investing in, and the level of risk.” It also considers the behaviour and risk characteristics of funds between regions.

Equilibrium’s study focused on an “institutional” approach to pricing, which sees clients paying reduced fund charges compared to retail investors. Such “discounts” make a difference to returns over the long-term and also to whether the average active fund outperforms or underperforms an index tracker, according to the study.

“We typically would pay no more than 0.75 per cent per annum for a fund which has a retail cost of 1.5 per cent. With the launch of new “clean” share classes, many retail investors will be able to access these sorts of deals from next year,” said Deverell.

As well as investigating whether the average fund can beat an index tracker, the study focused on whether there was any consistency amongst top performing funds.

“Even if the average fund tends to outperform the index, that’s no use if we cannot consistently pick an above average fund,” Deverell explained. “In some areas we found a top quartile fund in one period has a high chance of remaining in the top 50 per cent of funds, even up to five years later. This means that not only does the average fund beat the index but we have a statistically good chance of selecting a better than average fund.”

However, this was not the case for all sectors. In some areas, the average fund underperformed the index and there was little consistency amongst individual funds. According to the research, in those areas investors should select passive funds.

Index choice

The choice of index for those tracking passive funds is also identified, suggesting they can be as important as choosing the right active fund is for those with using an active approach.

For each area, Equilibrium’s research identifies choices which should be made. In UK all companies the study suggested both active and passive to be considered, whereas for UK equity income, UK smaller companies, Europe (excluding UK) and Japan, active should be the over-riding choice. Meanwhile, for North America and global emerging markets, the study suggests passive funds should be used.

This study was carried out by Mike Deverell, investment manager and Graeme Black, investment analyst at Equilibrium Asset Management.