Is it time to switch into active funds?

For a long time, we've preferred passive funds over active funds. But are passive funds starting to lose their competitive edge?

For a long time at MoneyWeek, we've preferred passive tracker funds (which just try to give you the same return as the underlying market) to actively managed funds (which aim to beat it). While it's true that some active fund managers succeed in outperforming the stockmarket, research still shows that on average they don't. And even if you pick a good one, the chances of them continuing to outperform consistently, year after year, are slim to non-existent.

This is partly because beating the market is tricky, but mainly because the high fees that active managers charge eat into your returns so significantly. So rather than get charged a lot of money in return for what's likely to be under-performance, we think you should pay a much smaller fee to get the market return.

However, says Elaine Moore in FT Money, passive funds "are starting to lose their competitive edge". According to research by Morningstar, despite the low fees charged by the likes of passive managers Vanguard, HSBC and Legal & General, the average total expense ratio of retail tracker funds is still 0.73%. "By comparison, Investec Asset Management's new clean' share classes for six of its most popular actively managed funds come with an annual management charge of 0.65%," says Moore.

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These changes and similar changes at other fund-management groups have been driven by the Retail Distribution Review, which banned commission payments to financial advisers in a drive to make the cost of investing more transparent.Prices for (some) active funds have dipped as such payments are stripped from fund-pricing structures.

However, while we'd agree that falling prices for active funds are a good thing, and that it can sometimes be worthwhile paying for active management (as long as you know exactly what you are looking for, and find a manager who is genuinely active', rather than just a closet index tracker), the data hardly makes a case for all passive funds being poor value.

Rather, the average seems to have been dragged up by certain firms such as Halifax and Virgin charging a hugely over-the-odds 1% a year for the UK index-tracker funds they sell to small investors. It's ridiculous that anyone should be paying this when the likes of Vanguard will offer the same sort of tracker for less than 0.2%.

So while it's good news that some active funds are cutting their fees, the real lesson here is: if you're planning to buy an index tracker, don't have the wool pulled over your eyes by big brand names.

Piper Terrett is a financial journalist and author. Piper graduated from Newnham College, Cambridge, in 1997 and worked for Germaine Greer and for Adam Faith’s Money Channel before embarking on a career in business journalism. 

She has worked for most top financial titles, including Investors Chronicle, Shares magazine, Yahoo! Finance and MSN Money. She lectures part-time at London Metropolitan University and is the author of four books.