Why you should always look for a passive fund first

John Stepek explains why you should always go for a passive fund over an active one, and outlines the two main types to choose from.

There's a story you often see in the money pages of the Sunday supplements at times when the market is flat or falling. It's one that never fails to amuse me. It goes like this: a pundit – usually someone whose job it is to sell funds – will grudgingly admit that most active fund managers fail to beat the market consistently. He'll accept that, in a rising market, there's a case for buying a passive fund, one that merely tracks the market higher. But then he'll add sagely: "Ah, but in a bear market like this, you want an active manager on your side." This'll be justified with some guff about how an active manager can use their "skill-set" to be more "agile", reacting nimbly to "ever-changing market conditions" like some sort of investment gazelle.

Read this nonsense in a Sunday morning haze, before your first cup of coffee, and you might think it makes sense. After all, if the market is going down, why would you want to track the market? You'll only lose money. So why not put your money with an active manager? At least they've got a chance of making you some money. That's got to be better than a guaranteed loss, hasn't it?

There are two reasons why this is complete rubbish. The first, minor reason is that most studies show that active managers fail to beat the market during bear markets as well as bull markets. So when markets fall, actively managed funds generally fall further and harder. So much for agility. But the most important reason is that the whole argument only makes any sense if there's only one place where you can put your money. And there isn't.

There are only two things you can control when investing

There are only two things you have any real control over when you decide to invest in something. One is the price you pay. Obviously you can't dictate your price: if BP shares are trading at £4 a pop, no one will sell them to you for £2. But you can decide on a price that you're willing to pay for an asset. You can then stick to it until either the market decides to offer it to you for that price, or you find a better option. In other words, no one is forcing you to buy something if you think it's expensive. 

So if you think the FTSE 100 is locked in a long-term bear market and that it's going to keep falling, then the answer is simple: don't use a passive or an active fund to buy it; don't invest in it at all. Ignore it, unless and until it falls to a level at which you want to buy. Instead, put your money in a different market. From China to Brazil to Japan to the US and everywhere in between there are plenty of places to put your money. And if you think stocks in general are doomed, then how about bonds? Or commodities? And there's always cash. Even a 0% return is better than a negative one. So there's never any need to invest with a mediocre “active” manager. There's always a better option out there.

The second thing you can control is your cost of investment. Investing always incurs some level of transaction costs. As we noted last time, the lower your costs, the bigger your returns. In short, regardless of what strategy you are following, your investment process will have two basic stages. You find an asset that you want to invest in; and then you find the cheapest way to invest in it. And the one thing you can say for sure about passive funds is that they are cheaper than active funds. Sure, they aren't always the best way to gain access to a given market. But they should be one of your first ports of call.

There are two main types of passive fund. One, usually known as a tracker fund, is similar to a unit trust, in that it is not listed. Instead you buy them through a fund platform. The other type is the exchange-traded fund (ETF). ETFs are listed on the stock exchange just like any other share. You buy and sell them (incurring the usual transaction fees, such as dealing costs) like a stock too.

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