There are, broadly speaking, two different types of investing, active investing and passive investing.
Active investing involves trying to pick the right assets to buy and sell at the right time. Passive investing entails tracking equity and bond markets and capturing market returns as cheaply and efficiently as possible.
Historically, active investing has been far more popular than passive. It’s certainly the style that most financial advisers have favoured.
But, as rockwealth Leamington's CHRIS WALLSGROVE explains in this video, although active investing may seem more appealing than passive, it has several disadvantages.
Evidence from the likes of Morningstar and S&P Dow Jones Indices repeatedly tells us that most actively managed funds underperform most of the time.
Transcript:
What is active investing?
Active investing is quite a simple notion in itself, really. if you're investing money, you're doing so because you want to, you want that asset to grow. You want to protect it against inflation. You want to use it to help you live the life you want to live when you're investing it. You have a huge range of different things.
There are thousands and thousands of things you could do with that money. You're buying something with a view to its growth. Typically that's a share in a business, its debt, or it could be property. There are all sorts of things it could be.
And the idea of active investing is that you or somebody you trust is making conscious decisions to buy or sell or buy that asset at specific times, in specific ways, to generate some kind of outperformance. They're also making decisions about exactly what to buy. Buying X is going to do better than selling Y, and so on. So making those active decisions is designed to outperform the market. And that's the notion of active investing. You're making conscious choices to buy things and sell things to generate that outperformance .
In short, because nobody has a crystal ball, you can have the strongest, most educated, most well-paid research teams, with access to all the data in the world, who can paint and tell really good stories about what's going to happen next and why it's going to happen next and why certain opportunities exist.But the key thing is, and the last few years have really rammed this home for us, there's always something around the corner that is not expected. Look over the last few years. We've had the COVID situation, we've had the Ukraine war, we've had inflation crisis, and that's just in the last few years.
You can't predict these things. So as good a story as it might be, we don't know what's going to happen. So getting it right in advance is impossible to do consistently.
What is market timing?
The notion of market timing is a really difficult one. It relies on people essentially trying to guess when the market's going to go up, or when it's going to go down, and to take profits or to get opportunities they wouldn't otherwise have had because of the time of that trade. So for example, in the COVID crisis, if someone could have understood that markets were going to tear away after they'd fallen down significantly, they would have invest edheavily at that point and benefited in full from that rise.
But of course it's almost impossible to get right. And the other key thing with market timing is getting it right when the market is about to fall as well. So, after markets have been rising and rising, you take your money out, bank any kind of profits, and put it in cash. And the difficulty there is, again, just getting it right, because no one has a crystal ball.No one knows. And we've seen this time and again in recent years. So the notion of market timing is getting it right, realising I'm doing it twice, getting it right on the way out and then on the way back in. And because nobody has a crystal ball, because nobody can foresee future events, getting it right twice on a consistent basis is almost impossible.
What about active funds?
Active fund managers have the same challenges that anybody else has, trying to invest in an active fashion. So they have to select stocks or bonds that are going to outperform. They have to engage in market timing, and they can have hugely well-resourced research teams. They can be very well-connected people.They can be hugely well-educated and work extremely hard. And they can paint really, really engaging pictures. The difficulty they have, though, crucially, is that they just can't predict the future, the same as everybody else.
These strong research teams, all of this extra work, all comes at a cost.So active managers are incurring an additional cost. to do all of this work for you, essentially taking bets that certain assets are going to outperform markets, that market timing is going to offer that additional outperformance. But again, getting it right consistently is extremely difficult.
Some do get it right. But what we tend to see is that, for example, if you look at fund groupings in any given year, or perhaps the last couple of years, the funds in the top quartile won't be there when you look in the next couple of years. And because of the costs involved, they've got quite a level of outperformance that they have to add in addition to the market as a whole in terms of adding value. So, yes, some do it consistently, but how on earth do you select in advance which funds are going to do it in the future? It's almost impossible. It's like looking for the proverbial needle in a haystack, really.
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