Active and Passive Funds – Pros and Cons

It’s an age-old debate among investors and investment professionals. Should you opt for active or passive funds, and what are the pros and cons of both? 

The great Warren Buffett, philanthropist, business tycoon and investment guru, knows a thing or two about hands-on investing. In 2014 he famously revealed that he’d directed that his wife’s inheritance should mostly be invested in a passive tracker fund even though his investment company clearly takes the active route 

If the world’s top investor sees the benefits of both active and passive funds, then surely others should too? Certainly, that’s our philosophy at Carrick. But before we delve into our thinking, let’s examine the fundamental differences between the two approaches, and if it’s more appropriate to choose one over the other. 

Pros and cons of active funds  

Active funds are run by human portfolio managers backed by analysts, economists and other investment professionals.  

On any given day these managers will invest in specific industries or business sectors which they believe have the capacity to outperform the market. Or they may be investing in individual stocks they expect to perform well. They could also be doing both. These investment teams constantly scan the markets and the wider environment – whether economic, political or social – for trends and market changes that present investment opportunities or threats. Based on these, they will adjust their portfolios accordingly. 

Their aim is to outperform the market. One way that top portfolio managers do this is to spot key trends early on and capitalise on them. An example is successfully anticipating how global regulators will legislate for such rapidly changing developments as the move to electric vehicles, and then to respond swiftly and appropriately by, for example, investing in Tesla and similar auto-tech companies before others do. Once everyone can see the opportunity, the share price becomes too high and the best prospects are gone. Similarly, active managers can take risk off the table when they believe there are too many headwinds, and the market may be due for a correction. 

And the cons? Active funds charge higher fees to clients and therefore need to outperform the market index by some margin to be a worthwhile investment strategy. 

The potential for higher reward also equates to arguably higher risk due to more concentrated portfolios and there are constantly scenarios unfolding that portfolio managers fail to anticipate or make the wrong call when adjusting portfolios – from pandemics to trade wars and irrational actions by politicians. To illustrate this point: Over the past five years, almost 81% of large-cap, active US equity funds underperformed their benchmarks. To quote Warren Buffet again “there is one thing worse than being wrong and that is being right at the wrong time”. 

Pros and cons of passive funds 

Passive funds don’t involve human decision-making and are tied to a specific index – for example the S&P 500 or the FTSE/JSE Africa Top 40 – which they will track through good and bad. This means that you will always be on par with the market, but will never beat it. In other words, lower risk due to more diversified holdings but no potential for outstanding reward. 

Pros include lower fees, plus, there’s little room for emotional responses – better termed ‘irrational decisions’ – during times of market crisis. The big pro, of course, is the more limited risk. And the big con is that your return on investment will never be better than average. Stellar performance is not part of the deal. 

Seek the best of both  

The reason that active and passive funds continue to be popular worldwide is because both work – but in different circumstances. At Carrick Wealth, we believe our clients can enjoy the best of both worlds. 

In fact, Anthony Palmer, Group Commercial Director at Carrick Wealth, says he finds the ongoing debate between active and passive managers unnecessary. “The Carrick Investment committee incorporate active and passive strategies in our investment solutions. We know that markets are inefficient over certain time periods and that active managers add significant value over these periods,” he explains. “We are agnostic to active versus passive and believe in having a combination of both. The key is to have a financial advisor and asset management team that is nimble enough to allocate between active and passive, as well as the transition between asset classes.” 

Steve Brooks, Training and Development Manager at Carrick Wealth, advises that cost shouldn’t be the primary determinant of whether to choose an active or passive strategy. “Examine the costs, but don’t let the tail wag the dog. ‘Expensive’ doesn’t mean better; nor does ‘cheaper’,” he says. “Seek value for money. There are times to be ‘active’ and times to be ‘passive’.”