Here's Why Active Funds Are More Expensive

LONDON – The debate between active and passive investing has been ongoing for over two decades now with researchers trying to determine which of the two investing styles is better. Although most results are not fully conclusive, passive investing seems to be winning in terms of assets under management (AUM).

The chart below, published by ETFGI, illustrates the rapid growth of passive products in the last 20 years. Although hedge funds are only a subset of the active manager universe, we use this illustration primarily to highlight how quickly passive investing has grown in the last two decades.

At the end of the second quarter 2015, the AUM of exchange traded funds (ETFs) and exchange traded products (ETPs) on a global scale rose to nearly $3 trillion and surpassed that of hedge funds for the first time in history.

So why is money flowing into these passive products?

To answer this question we ran a simple analysis, in which we compared the performance of all funds which make up the Investment Association's (IA) Flexible investment Sector to the FTSE All Share Index between January 2006 and September 2015. The results were not surprising and were very much in line with the existing research.

We found that active fund managers on average outperformed their benchmark on a gross level (before commissions and fees) by approximately 1 percent, showing that they possess some skill. However they have underperformed the FTSE UK All Share index after the deduction of fees and expenses by around 0.6 percent. This indicates that the primary drag on performance of active fund managers is cost.

Higher Fees: Worth The Cost?

So why do active managers have such high costs?

1. Expensive investment specialists: Actively managed funds are run by multiple teams of investment specialists covering different sectors and asset classes, each charging a premium for their investment advice/views.
2. Administrative Costs: A good portion of money is spent in sales, marketing and administrative activities of the fund.
3. Trading costs: Active funds by nature trade more often than passive funds, incurring higher trading costs which then get passed on to the end investor.

Passive funds, like the name suggests, simply track a market index and charge minimal fees. They do not require multiple teams of investment specialists and trade less compared to active funds, therefore incurring lower trading costs. Total expense ratios for passive funds are typically lower than 0.5 percent. The main disadvantage to using passive funds is that it will move in line with the index it is meant to track. It is fine for investors during periods of positive performance of the index, however potentially frustrating for the investor during market falls, as a passive fund manager will not take any action to stem the losses.

Pros And Cons

Active and passive styles of investing both have their pros and cons. It is true that there are some very skilled active managers out there who have consistently outperformed their benchmark but due to an abundance of actively managed funds, it has become increasingly difficult to identify such managers. The large sums of money flowing into passive funds is testament to the fact that the industry has accepted these funds as a viable alternative.

Pros and cons of each style have now been widely understood and sophisticated investors have begun to use a blend of the two investing styles to meet their investment objectives. One way to blend the two styles is to use passive instruments to gain required asset class exposure, but instead of having a buy-and-hold strategy, regularly rotate asset classes depending on the macro-economic environment to add alpha. These tactical asset allocation strategies have gained popularity as they are specifically designed to limit the downside by moving out of risky assets during market downturns but participate in the upside by moving into risky assets during bull runs.

At Copia Capital, we believe that tactical asset allocation is what drives investment returns and in order for the investor to realize these returns, we strive to keep costs are as low as possible. The widespread availability of ETFs and tracker funds has made it possible for us to gain required asset class exposures at a very low cost, while our quantitative algorithm enables us to perform active asset allocation, delivering superior risk-adjusted returns with low transaction and operational costs. We believe there is a place for both active and passive styles of investing and, if used correctly, an investor can combine the best of both worlds to achieve results better than each style individually.

Hoshang Daroga is quantitative investment manager at discretionary fund manager Copia Capital.