The only way for active investors to survive the passive onslaught

I've seen several attacks on passive investing recently.

One manager in the Financial Times the other day compared passive investing to antibiotics good in moderation but disastrous if overused.

Putting aside the slightly odd metaphor, thenew line of attack on passive investing (usually from active investors) goes something like this.

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If money is just flowing blindly into the biggest companies, then you're getting both capital misallocation (so that good companies are starved of money and bad ones just keep getting it), and poor corporate governance. No one is holding these companies to account.

That's all very well. But you can make the same criticism of active management...

Active or passive? It's the same fundamental decision-making process

Say you want to invest in UK equities, and you decide to buy an actively managed fund. At a quick glance, the Investment Association currently lists 220 such funds (unit trusts or OEICs, not investment trusts) in the UK All Companies sector.

Pick one of these funds at random, and chances are it'll be benchmarked to the FTSE All-Share index, or some variation on the theme. The manager will pick stocks from a set universe (UK-listed companies, by and large). They will have an underlying theme or strategy or view that informs their choices (hopefully!).

Some of the managers will use "value" strategies (so they'll look at the fundamentals, and buy stuff that's cheap based on various metrics). Some of the managers will use "growth at a reasonable price" strategies so they'll be happy to pay what looks like expensive multiples for "good" companies.

Some will invest based on "growth" they'll buy expensive stocks that are growing fast.Some of them will invest based on momentum they'll just buy what's going up. And others will be closet trackers they'll try to hug the index as much as possible to avoid getting fired.

Strategies go in and out of style, of course. I've always leaned towards value investing the mix of margins of safety and bargain hunting suit my mentality but it doesn't always work. Some years are growth years. Other years are value years.

But chances are you'll pick a style that you feel comfortable with. Alternatively, a lot of investors tend to pick the fund that has done best recently, usually just in time for its performance to turn down.

Anyway that's your choice when it comes to active funds. You find an area you're interested in, and a style you like, and you buy based on that.

Spot the difference well, apart from the charges

The question is, how is this any different to "passive" investing? Let's say you decide you want to buy UK equities, but you don't want to pay up for an active fund manager. You look at the tracker funds and exchange-traded funds on offer.

There are some plain vanilla index trackers. They'll give you the performance of the FTSE All-Share, less a small fee. Over time, you'll probably outperform the majority (not all, but more than half) of the UK-focused active managers you have snubbed.

Alternatively, there are "smart beta" options. These track a different index one based on "value" metrics such as price/earnings ratios, or price/book, say. Or one based on high-yield stocks. Or one based on "low volatility" stocks.

You have to understand what the index is actually trying to do you have to understand what the strategy is. And you'll have to pay a bit more for these sorts of trackers.

But fundamentally, there's no difference here. You're choosing an area to invest in, a style that you're happy with, and you're buying based on that.

You can argue about money simply chasing performance dashing after the biggest stocks. But that's been a long-standing criticism of big active fund managers too.

Take the example noted above, of the UK All Companies sector.With a few notable, independent-minded exceptions, you will struggle to find an active fund that doesn't own the biggest stocks in that index the likes of HSBC or BP, for example. Given the benchmark, it's inevitable. At best, the manager will have made a judgement to "overweight" or "underweight" that stock.

So forget passive funds there's plenty of "dumb" money just flowing into the biggest stocks via the active sector.

And as for corporate governance, it's only very recently arguably in reaction to competitive pressure from passive funds and more importantly, pressure from the government that more active funds have been trying to hold managements to account over pay packets, for example.

I'm not saying that this is ideal. But at worst, passive funds are just committing the same sins the active industry always has they're just doing it more cheaply.

As I keep saying, the reality about "passive" funds is that they simply offer a different way to implement your investment strategy. You still have to make "active" decisions as to what to buy and when.

If you want someone to take those particular decisions off your hands, it's a wealth manager you need. And these days, the decent ones will largely take your money and stick it into passive funds, because they're cheap and reliable.

What about the longer run?

When you look at it like this, passive funds are simply a more rigorous and efficient method of investing in a particular market. These funds won't suffer from "style creep" (where an underperforming active manager abandons their strategy in the hope of making up their losses).

They won't get offered more money by a larger rival, or be moved to a bigger fund where their expertise is swamped by the weight of expectation and assets under management. Instead,they'll do exactly what they say they will whether it works or not.

And in the longer run, I think that passive investing and its offshoots are likely to make the market more, not less, efficient. "Vanilla" trackers will kill off expensive actively-managed closet trackers and index huggers.

Meanwhile, competition between index providers will drive more and more research into what actually works in the market. New "smart beta" funds will come and go, and the most successful will hone in on any mechanical strategies that can outperform the market, and arbitrage away those differences.

At that point, the main traits that an investor will need are those that a mechanical strategy will struggle to implement imagination, intellectual flexibility, and humility. The ability to change his or her mind, to imagine a world that is different to the world of yesterday and today, and the temperament to be able to do that without getting too attached to any one view.

That's proper contrarianism. That's hard. And it will always be hard. And that's why there will always be a place for truly active investors, even amid our near-perfect robot future.