Are investors now too passive?

Investors are increasingly settling for matching a market's performance rather than trying to beat it. But they could be missing a trick, says Piper Terrett.

Ever-increasing numbers of investors are ditching high-cost actively managed funds and buying passive trackers' such as exchanged-traded funds (ETFs).

These simply aim to track an index such as the FTSE 100 or the S&P 500 as closely and cheaply as possible, rather than beating it. But by always settling for just matching the market, could they be missing a trick?

Dan Hyde in The Daily Telegraph claims that "savvy investors" know that the chances of success with a tracker or an actively managed fund depend on "the region and the type of shares involved".

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Areas such as emerging markets and small-cap stocks offer managers plenty of chances to outperform. In comparison, doing so is harder in highly efficient markets such as the US.

Research done by broker Rplan backs this up, he claims: while 61% of US active managers failed to beat the average US passive fund over five years, 66% of UK fund managers succeeded in doing so. In emerging markets, 74% outperformed, while in Europe an unbelievable 99% did so.

Do these findings blow a hole in the arguments for passive investing? No. There are two common problems in measuring fund performance that are likely to be at work. One is specifying the wrong benchmark.Comparing a US small-cap active fund against the S&P 500 tells you nothing about how well it's done, because small caps outperform large caps over time anyway.

The second problem is survivorship bias'. Fund firms often shut down underperforming funds, due to the difficulties of selling investments with a poor record. So when you look back at the past performance of active funds available today, the group will typically have better pastperformance than those that fell by the wayside.

These problems mean that different studies can produce very different results. For example, independent financial adviser AWD Chase de Vere found that the average active fund failed to beat its index in virtually all sectors including UK equities, European equities and emerging markets, according to a report in January again in The Daily Telegraph.

More importantly, rigorous research carried out by academics rather than by financial services firms consistently shows that the average active manager underperforms after costs. This doesn't mean that no active manager can beat the market long term, but finding those who are genuinely capable of doing it is tough.

If you're willing to do the work and develop the knowledge needed, it can be worthwhile. However, for most investors, the low-cost passive option is the best bet.

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.