Active vs Passive INVESTING

Active vs Passive INVESTING

INTRODUCTION Active versus passive. Both are fundamentally different approaches to investment management and each has clear benefits and disadvantages. An understanding and awareness between the two approaches can help ensure that the ones an investor picks for their portfolio are best placed to meet their investment goals. Why invest in an active investment strategy? Active investing is a strategy that aims to meet a specified investment objective through the active selection of stocks in line with fund managers individual investment strategies. There are many different ways in which active managers seek to achieve their fund objective. Common to all, however, is the belief that by using skill and proven investment processes, it is possible to beat the market. Active funds are not tied to the stock or sector weightings of an index. They have specific performance objectives, with managers selecting stocks according to individual investment strategies. The managers can make informed decisions to exploit the inefficiencies of the market and with anticipation of changes in market conditions they can adjust the balance of their funds accordingly. So in turn, investors can choose to invest in funds that match their specific requirements, such as income or capital growth. With choosing an active investment strategy, the fund fees are usually greater than those for passive funds, but so too are the potential rewards. Why invest in a passive investment strategy? Passive investing is an approach that aims simply to match the returns of a financial market, as measured by an index such as the FTSE 100 Index of leading companies in the UK. Passive funds can be easy and quick to trade in and out of and they are also highly transparent investors know at any time more or less exactly what is held in their fund. And, importantly for some investors, by tracking the market, passive investing generally avoids the risk of underperforming the market return by a large margin. Passive fund charges tend to be lower than that of active funds. This is due to the difference of investment approach to active investing with the higher costs levied by fund managers and their team of analysts.

An example profile of an active investor An investor in an actively managed fund typically believes that an active approach to investment management is a good way to achieve their investment goals over the long run. They may have a specific requirement, such as a growing level of income, which an active fund can be designed to provide. They also believe that the higher fees are justified by the potential for long-term outperformance or an investment product better suited to their needs. The active investor aims to beat the market, and is not prepared simply to settle for the average return. Active investors understand the risks of stockmarket investing, and that these need to be balanced with the potential returns. They have the confidence and knowledge to set their own investment objectives, often having taken expert advice, and are prepared to pay for the expertise to achieve their aims. An example profile of a passive investor The passive investor is not concerned with above market average returns on their investment. So this style of investing is for those who are satisfied simply with earning the market rate of return. Passive investors can also be short-term asset allocators, in which case they could use passive instruments that allow them to move money around quickly. Passive investors may well want a low maintenance investment. They may not want to be troubled with monitoring a fund manager s investment decisions. Alternatively they may consider that they simply don t have the knowledge to make active investment decisions, or to select someone to make those on their behalf. If you choose the right active fund manager, the gains you can make generally outweigh the costs. Benefits and disadvantages of active investing The pros Your investment may be able to outperform the market History shows that the best actively managed funds have beaten the market index significantly over the long term. Flexibility to move in and out of stocks and sectors Active funds aren t tied to the stock, sector or regional weightings of any particular index. To keep their value when markets are falling, they can move out of investments which are likely to suffer most. They can also reduce their weightings in entire sectors and regions, or in the case of some funds, ignore them completely. And, of course, they can increase holdings when the fund managers have a more positive view. A variety of investment styles and strategies Active investors can choose from many management styles and strategies to find the ones that best suit their fund s investment goals and their attitude to risk. and the cons Performance depends on the skill of the manager There s the risk of investing in an actively managed fund that performs poorly and fails to beat the index over the long term. Higher costs Higher management fees are required to pay for the expertise and resources needed for active managers to make informed investment decisions, compared to passive funds. Time and effort Active investors need to put time and effort into researching a range of funds before choosing a fund to invest in.

Benefits and disadvantages of passive investing The pros You know what you re getting You know what investments will be in your fund, and you know you ll generally be getting close to the market return. Little risk of underperformance It s unlikely that a passive fund will underperform the market index by a wide margin. Cheap and easy access to the market Management fees are usually less than for an active fund. Passive funds can also offer a quick and easy way to trade in the stockmarket. Exchange-traded funds (ETFs) can be bought and sold throughout the trading day. Opportunity to outperform Tracking an index can indeed be more risky at times of market extremes whereas an active manager can make a judgment on valuation and diversification. For example, during the technology boom in the late 1990s, inflated valuations lifted the market capitalisations of many technology stocks, which subsequently increased the technology sector s index weighting to an abnormal level. A similar scenario occurred in 2007 with financial stocks. On both occasions, a passive investor would have lost out through index distortion. and the cons Lack of choice By choosing a passive fund, you are restricted to investing in a near replication of a market index, so you ll only have the potential to earn the average rate of return. Little prospect of outperformance There is little potential for a passive fund to outperform the market. Lack of diversification As passive funds try to replicate the stocks in an index as closely as possible, they are forced to hold big stakes in the larger companies and sectors in that index. If these perform badly, this would have a significant impact on the performance of the fund. 100 invested each month in one of the top quartile performing active funds in the UK equity sector* would have returned considerably more than the same investment in a passive fund in the sector as shown in the chart below. 25,000 20,000 15,000 10,000 5,000 100 invested per month for the past 10 years 19,180 17,039 15,477 16,074 Source: Morningstar, Inc. IA UK All Companies sector as at 29 February 2016. Figures in GBP, bid-bid, net income reinvested. Final investment value calculated using monthly returns over the 10-year period for those funds in the IA UK All Companies sector which have the FTSE All-Share Index as the primary prospectus benchmark, as stated by Morningstar. Average performance of tracker funds is based on the 15 tracker funds in the sector which track FTSE All-Share Index and have a 10-year track record. Average of active funds is based on all active funds and the average of top quartile funds is based on as average of those funds which have delivered top quartile returns in the sector over a 10 year period. 0 Average of tracker funds FTSE All-Share Index Average of active funds Average of top quartile funds*

Educating yourself and clients Motives for investing? Investors have different motives for investing: Some want capital growth; some a steady income. Some want secure returns through investing in low-risk, high-quality securities; some are willing to take on more risk for the potential of higher returns. Some are simply looking to diversify their portfolio by investing in a wide range of companies Choosing the right active manager? In a population of over 6,000 active funds available in the UK, how do you pick one that will consistently outperform? Look for an active fund manager with proven ability to outperform the market, one with a consistent track record, and who is independently recognised. Although active funds have higher charges, active investors understand the principle of you get what you pay for. They are prepared to pay the higher costs associated with a skilled active manager with the resources to make the right stock selection decisions. Questions investors might ask before selecting an active investment: Do the investment objectives of the fund match my personal goals? What is the level of experience and long-term track record of the fund manager? And of the fund management company itself? What level of resources does the fund management company, and hence the fund manager, have in terms of research, risk management and dealing capabilities? Has the fund been recognised externally for example, by awards or ratings? What we believe We are passionate about active investing at M&G and for over 80 years we have built a strong reputation for investment integrity, original thinking and innovation. We are firm believers in the benefits; however, we recognise that some investors will prefer the low cost option and will choose a passive investing strategy. In our view, both active and passive strategies are crucial for markets to function effectively and have their place in a well-structured portfolio. Active strategies can be set up to perform well in a variety of market conditions, whereas passive funds do not have this flexibility. Moreover, active strategies cannot be easily replicated by an index, particularly where they focus on the human element for assessing companies. Active strategies can be set up to perform well in a variety of market conditions, whereas passive funds do not have this flexibility. Conversely, index-tracking funds may work during a rising market, but look less attractive when markets are falling or moving sideways. A good active manager will be able to take advantage of all market opportunities as they have the flexibility to invest away from the index and to focus on the human element that passive strategies are unable to recreate. We believe this human element, combined with the resources and skills that we have at M&G, will continue to make the case for active management and have the potential to deliver outperformance for our investors. Questions which could be discussed with clients before selecting a passive investment: Are you satisfied with earning the market or average rate of return? Is cost particularly important to you? Do you not feel confident in choosing one of the actively managed funds that could outperform the index? Are you happy to hold whatever stocks make up the index?

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