Should you buy active or passive funds?

What's the difference?

An active fund is one run by a manager who spends his or her time researching, picking and trading stocks with a view to outperforming the stockmarket as a whole. A passive fund buys all the assets in a particular market or sometimes a representative sample of them with the aim of earning the same returns as the market, not outperforming it. Passive funds are also known as tracker funds or index funds, as they track the components of a given stockmarket index.

I wish I knew what the PEG ratio was, but I'm too embarrassed to ask

A price/earnings-to-growth (PEG) ratio is used to try to spot undervalued shares. It compares a company's price/earnings (p/e) ratio with the expected growth in its earnings per share (EPS). To calculate it, divide the p/e ratio by expected annual earnings growth. The PEG ratio is seen by some investors as a better way to weigh up a company's value than relying on the p/e alone, because it takes growth into account. Hence the ratio can be a useful tool for comparing companies in similar industries. For example, one company might have a p/e of 15, but expected earnings growth of 20%, giving it a PEG ratio of 0.75 (15/20). Its rival may also have a p/e of 15, but expected earnings growth of 5%, giving it a PEG of 3. However, it is important to be aware that the PEG ratio is merely a crude rule of thumb, and is not built on rigorous financial theory.

Which one is best?

If you are working entirely on price, the answer is passive: most of the day-to-day decisions are taken by computer, and they are cheaper than people, so passive funds are almost always much cheaper than active ones. If you are looking at average overall returns the answer is also passive. These will obviously automatically underperform all markets slightly: subtract the fees you pay for them from the index return and you end up with a little less than the market return. But as long as they track the index relatively closely (some are badly constructed and so don't even manage that), it is generally accepted that the average tracker outperforms the average active fund. That's partly down to cost, but even a reasonably priced active fund is likely to come in at ten times the cost of a passive fund. When returns across the board are low, that matters. Another reason to avoid active funds is because, regardless of fees, very few fund managers are capable of outperforming any given index for very long.

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Aren't fund managers any good at investing then?

On average, no. A Vanguard study in 2014 looked at the records of all funds in the UK listed on data provider Morningstar. The results were miserable. More than half of the funds failed to beat their index over 15 years. In ten out of 11 of the sectors looked at, 75% failed. Over ten years 70% failed and over five years 50% did. So if you had picked a fund at random over any time period, you would have had at best a 50/50 chance of paying a manager very significantly more than a passive fund to underperform a passive fund.

Of course, no one picks a fund at random. But picking a good one is very, very difficult. Vanguard also looked at how many funds managed to stay in the top quartile of funds from one five-year period to the next. The answer was a mere 12.8%. Worse, over 40% of them fell into the bottom 20% of performers. Other studies back this data up. Last month, for example, Standard & Poor's showed that 66% of large-cap, 57% of mid-cap and 72% of small-cap managers underperformed their relevant S&P benchmarks in the US during 2015. And of the 700-odd that were top quartile in the year to September 2013, a mere 4.3% were still hanging on in September 2015.

Are there any good active funds?

There are a few excellent funds out there and there are some things that they seem to have in common. They aren't too big (size kills performance). They have a high active share (this just means that their portfolio is very different to that of the index a whole). Their managers are invested heavily in the fund themselves. They have a clear strategy and the stamina to stick to it. Their turnover (which is a huge component of their costs) is low.

And, crucially, so are their fees. If you must invest in active funds, look for one with as many of these characteristics as you can and place a particular focus on the overall cost. Remember that a manager who beats the index by two percentage points a year but also charges you two percentage points a year isn't much better than one who doesn't beat the index at all but charges you 0.1% a year. Finally, before you buy, look back to the paragraph above and ask yourself how lucky you feel lucky enough to have chosen one of the very few funds that might outperform over the long term, or not?

Is there a downside to passive?

There is. Passive funds have less interest in the corporate governance of the firms in which they invest than active firms they just buy what's in the index, be that good or bad. Their managers have little incentive to kick up about CEO pay or environmental issues, for example. They also lock investors into what is effectively a momentum strategy as the price of a share rises and it takes up more of an index a passive fund automatically buys more of it and vice versa. Finally, it is worth noting that not all funds can be passive. It might make sense for individuals to minimise their costs and maximise their returns, but if everyone were a passive investor there would be no market: price discovery relies on active investors.