I can’t see why you’d ever use an active fund to invest in big US stocks

"Passive might be fine for bull markets. But when a bear market comes along, you'll want an active manager who can be nimble and save you from the worst of the damage."

If I had £1 for every time I've heard this gem or a version of it, I'd be writing this email from a sunny beach in the tropics, rather than a train rumbling through drizzly Kent.

This idea that active managers can deliver the goods when markets fall is remarkably persistent.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Yet, as with much conventional wisdom, it's completely wrong and not based on anything you could respectably call "evidence".

The latest data from the October mini-crash merely proves the point.

Active managers fail to beat the bear again

Last month, notes the FT, the S&P 500 fell by 6.9%.

So how did active managers investing in US large caps (S&P 500 stocks, basically) do over the same period?

Not very well, is the answer. The average large-cap fund saw its value drop by 7.5%. In other words, the average manager failed to beat the index.

In all, four in ten large-cap managers managed to beat their benchmark in October. (Note, this means they managed to lose less than the benchmark, not that they actually made any money.)

So much for "passive is fine for a bull market, but active managers come into their own in bear markets."

And despite the fact that this has been a much more volatile year than 2017 and therefore should have provided more opportunity for active investors to demonstrate their skill the reality is that they've done much worse this year than last.

As the FT notes, the percentage of stocks held by active managers that have beaten the benchmark has fallen to 39%, down from 55% this time last year. (I imagine though I don't have the data that they were all holding tech last year, and are still holding tech this year.)

It's another stick to beat active investors with. And usually I'd take full advantage of the opportunity.

However, I'm worried that simply using this as an excuse to slag off active managers distracts from a much bigger issue. Which is that at the end of the day, if you are investing in a sensible manner, this whole "passive vs active" argument should be virtually irrelevant to you.

What to think about before you invest any money in the US (or elsewhere)

The implied question raised here is: should I invest in US large-cap stocks using a passive or active fund?

In reality, the question any investor needs to consider first is: what proportion of my assets if any do I want to invest in large-cap US stocks?

You have a specific pool of money (be it a lump sum or a regular dripfeed) to invest in meeting your long-term financial goals (typically retirement; potentially children's education if you start early enough; but probably not a deposit on a house, because your time horizon is probably not long enough).

You have to consider how to split that pool of money between the wide array of investment assets in the world. I like to keep these things relatively simple. So I start from the idea that there are five core asset types: equities (stocks or shares); bonds (IOUs); property (which is really just a subset of equity); gold (effectively financial insurance); and cash (which gives you optionality the ability to act in a hurry and will always maintain its nominal value).

So before you consider investing in US large-cap equities, you have to think about how much of your overall pool you want to put into equities in the first place. That'll depend on your risk tolerance, which should largely be informed by your time horizon. Put simply, the longer you have to meet your goal, the more equities you can afford to hold.

Once you've made that decision, you can then decide what proportion of your equity allocation you want to invest in big US stocks.

How do you make that decision? It boils down to how active you want to be. The US is a very important equity market. It has a lot of companies that you can't get access to versions of elsewhere, most notably the likes of Apple, Amazon and Google (Alphabet). So there are very good reasons to have some exposure to the US market in your portfolio.

So if you don't want to be very active at all, then you might decide that you want your holdings in the US stockmarket to broadly reflect their significance in global markets.

So you might look at what proportion of the global index is taken up by US stocks (it goes up and down but it's roughly 40%). In effect, if you have less than that amount in the equity part of your own portfolio, then you are "underweight" the US. More, and you are "overweight" the US.

However, you might note that US stocks are very expensive, judged by history. So if you are willing to be more active taking the time to review your asset allocation percentages once every six months or so, say then you might want to find a method by which you "underweight" expensive areas and "overweight" cheaper ones.

You could use a number of valuation measures for this, but the important thing is to have a system. If you don't have a system you can stick to regardless of whether it's ultimately the best system or not you will allow human error to creep in and you will end up with a mess instead of a portfolio.

Passive or active? In this case, the answer is almost certainly passive

So you've now decided how much of your portfolio you want to dedicate to US large cap stocks. Only now should you even care about the question of whether to go "passive" or "active".

A passive investment will just track the index. When the S&P 500 goes up, it'll go up. When it goes down, it'll go down. But you know that you'll get the index return. And given that you've decided that US stocks are worth having in your portfolio, then presumably that means you think that they'll go up in the long run.

Should you use an exchange-traded fund (ETF) or a unit-trust-type tracker fund? In a market this big, I'd worry mostly about the cost. Just go for whatever's cheapest (bear in mind your broker's charges and how regularly you'll be investing in the fund this may make a big difference as to which structure is cheaper).

In this context, why might you consider an active fund to track US large caps? To be honest, I'm struggling to come up with a reason. Remember that most active managers have much less freedom than you might think. If you are a US large-cap fund manager, then that's what you can invest in US large-cap stocks.

Given that you can invest in a US large-cap tracker for virtually nothing these days, it's extremely hard to see what value anyone but the most exceptional manager can add over the long run. Remember the active manager not only has to beat the market, they also have to earn back enough to pay off their own fees before you are winning.

If you pick an active US large-cap manager at random, your odds of getting the one who beats the market are much lower than 50/50. If you put a lot of research into it, you might improve your odds, but I'd be willing to bet that they're still less than 50/50.

So, in short, is it worth spending any time on trying to pick the one US active manager who you think has a chance of pulling it off? Or is it better to spend that time and effort on figuring out what to do with the rest of your portfolio?

(It's definitely the latter, in case you are struggling.)

Now I'm not saying that you should always use passive investments. For example, if I want exposure to US large caps, I'd be far more inclined to stick something specialist (like investment trust Scottish Mortgage Trust) into my portfolio, and have that account for at least part of my US exposure.

And maybe I don't want an S&P 500 tracker. Maybe I'd favour a fund that invests in US large-cap value stocks (although even then, you still have a wide choice of tracker funds you don't necessarily have to go active).

But if you just want "big US stocks" in your portfolio, the S&P 500 is a fine choice. And it's easy to get cheap, predictable exposure to that without fretting over which manager might be the next Warren Buffett.