How many times have you heard this old chestnut?
"Passive funds are fine when the market is going up. But when the market falls, and the bear starts to bite, that's when active managers really earn their keep."
It sounds like it makes sense. Passive funds can only follow the market up and down. They can't take action to insulate you from a fall. If the market crashes, so does your passive fund.
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An active manager, on the other hand, can take evasive action. And they can hold more cash something a passive fund can't do.
It all makes a lot of logical sense.
Sadly, it's also tripe.
Guess what? Most active managers underperform when markets fall too
In the year to the end of June, just over 80% of UK equity fund managers failed to beat the UK index. That's according to the latest scorecard from S&P Dow Jones Indices.
What's all the more painful for active managers, is that this came at a time when they're meant to demonstrate their value (at least, according to popular myth).
The latter half of last year was a rough year for markets. Indeed, it's easy to forget now because the early 2019 rebound was so strong, but in the last quarter of 2018, markets really fell hard. It looked as though it might all be over.
And yet, despite the widespread bear market, active managers failed to take advantage.
As Andrew Innes of S&P Dow Jones points out, "the steep declines seen across equity markets in late 2018 were accompanied by near-ubiquitous underperformance across the fund categories' asset-weighted returns."
In other words, while markets fell, active funds fell harder. And that goes for whichever benchmark you want to choose.
Worse still, the managers were unable to make the money back during the rebound in 2019. Talk about adding insult to injury for their investors, at least.
The one thing you can take charge of
We've said it many times before and I'll warrant we'll say it many times again in the future: if you want to maximise your returns as an investor, the key thing to focus on is costs.
None of us can predict the future. And even if you did know what was going to happen next, markets in general take an almost perverse delight in confounding expectations. So you can never be sure of how they're going to react in a given situation.
So you have to focus on the things you can control. The nice thing about doing that is that it narrows down your options very rapidly. Because as an investor, there's very little you can control.
You don't know which active fund manager is going to be the one to succeed (you can increase your odds of finding them stick to investment trusts but that's a story for another day). You don't know what the Bank of England and the US Federal Reserve are going to do next. You don't know how Brexit is going to turn out, or how the market will react if it does.
But there's one thing that you can control: how much you pay to invest.
One of the main reasons that active managers struggle to beat their benchmarks is because they not only have to beat the average, they also have to make enough on top of that to pay for their own fees before you start seeing the benefit.
This, of course, is where passive funds come in. Passive funds don't try to beat the market. Instead, they aim to track the market. Tracking the market isn't hard, because you just have to invest in the same stocks that the market does.
In turn, that means that the fund doesn't require an expensive fund manager or management team to run it. As a result, it can charge lower fees.
So you have a fund that promises to give you the average in a world where achieving the average is counterintuitively an above-average result. Not only that, but it promises to deliver you this result at a lower cost than any active fund.
In short, if you want to invest the straightforward way and you have no desire to spend ages picking over research to try to find the best fund manager (and potentially then getting it wrong anyway) then you should favour the passive route every single time.
Don't get me wrong this is just the beginning. You then still have to consider which passive funds you might buy. That all comes down to your asset allocation how much money do you want to invest in bonds? How much money do you want to invest in equities? Which bond markets? Which equity markets?
This is a topic I've covered many times before, and which I will no doubt cover many times again. But, for now, this is the point to bear in mind: watch your costs. Over a working lifetime it can make tens or even hundreds of thousands of pounds of difference to your eventual retirement pot.
This will, incidentally, be among the very many topics we'll be discussing at the MoneyWeek Wealth Summit on 22 November. If you are at all interested in how to better protect and grow your wealth, then I suggest you book your ticket here.
John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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