Introduction to active and passive investment management

10.09.2020
Ricky Banham
Financial Planning

A tracker fund is a simple way of investing your money in company shares, bonds, and other assets.

It aims to mirror the performance of an index, which is a collection of assets that represents how a particular market is doing. For example, the FTSE 100 index shows how the shares of the 100 largest companies in the UK are performing.

Tracker funds will generally use one of two strategies. The straight-forward version is ‘full replication’; this is where the tracker fund buys all the investments that make up an index. Taking the FTSE 100 as an example: a tracker fund would buy shares in all 100 companies in that index, in proportion with their weighting in the index itself. So, if 6% of the index is represented by a particular bank, a fully replicated tracker would invest 6% in that banks shares. This is the simplest method of tracking.

The alternative is ‘partial replication’. Tracker funds using this approach do not buy all the assets in an index; instead the tracker fund buys the assets the index is trying to mirror. These tracker funds exercise discretion, as buying the full index can prove prohibitively costly. An example is the MSCI World, which covers over 1,600 businesses in 23 countries. The Morgan Stanley Capital International (MSCI) is an index used to measure equity market performance in global emerging markets.

A major benefit in utilising tracker funds is they are traditionally cost-effective, with more scope left for growth potential over the longer-term.

Investing in tracker funds is referred to as ‘passive’ investing across the investment industry.

How do tracker funds react when the market falls/rises?

Put simply, the value of your investment will fall too. On the contrary, should markets rise, so will your value.

What is the alternative to passive investing?

This often leads investors to consider ‘active’ fund management, where the fund manager and team of analysts selects specific assets, with the aim of delivering investment returns that surpass the funds index or benchmark. The assets are actively managed by the fund manager, with decisions on buying, selling, or holding to achieve the investment mandate. Some investors have a specific interest in an asset class, such as an equity market, Property, or ethical focus, the investor will look to gain exposure

Unlike their passive counterparts, the fees associated to active investment manager are higher due to the additional flexibility, resources and research involved, in running the fund(s). Active fund managers are able to minimise potential losses by avoiding certain sectors/regions.

Key takeaways

·         Active management requires frequent buying, selling, and holding, in an effort to outperform a specific benchmark or index.

·         Passive management replicates a specific benchmark or index in order to match its performance.

·         Active management strives for greater returns, but take a greater degree of risk and are synonymous with higher running costs.

The debate over the respective merits and shortcomings of active and passive management may have begun several decades ago, but it remains one of the most divisive issues in the world of investing. 

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