Should you stick to index funds, or can you justify a blended approach?

Financial advisers around the world are increasingly recommending a blended investment approach that includes both actively and passively managed funds. But is it a good idea? In the sixth and final articles in this series on the cost of investing, we take a closer look at the evidence.

With passive investing growing in popularity, it has become quite common lately for fund management companies to advocate a blend of active and passive funds. It makes for an appealing marketing message, but is it actually in an investor’s best interests to combine the two?

First, you need to think about who is recommending a “best-of-both” approach. Most fund houses offer both active and passive, but because active funds are much more expensive, the profit margin on them is greater, which explains why companies are more likely to promote their active funds than their passive funds.

Fact or fiction?

Typically we hear firms say that while indexing make sense in a heavily researched market such as UK or US equities, active funds work best in less efficient markets. However that isn’t borne out by the data. As research by the likes of S&P Dow Jones and Morningstar has shown, active funds tend to fare just as badly in supposedly less efficient markets — emerging markets, for example — as they do in more established ones.

It’s often claimed as well that while index funds perform well in bull markets, active funds are the way to go in bear markets. Again, it sounds plausible, but it isn’t true. The data tells us that active funds tend to fall just as far as index funds, if not further, when markets head southwards.

The bottom line is that very few active funds outperform the market over the long term, on a cost- and risk-adjusted basis, and identifying those winners in advance is a major challenge.

Simple arithmetic

Ultimately it all boils down to cost. In a paper published in 1991 called The Arithmetic of Active Management, the Nobel Prize-winning economist William Sharpe invited readers to imagine the global investing community divided into two — active investors on the one hand and passive investors on the other. In aggregate, investors receive the market return.

We all have to pay to invest, but active investing costs considerably more than passive, and that makes a critical difference. Before costs, the return on the average actively managed pound will equal the return on the average passively managed pound. After costs, it will be less than the return on the average passively managed pound. So the average active investor must underperform the average passive investor.

To quote William Sharpe: “These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”

Are there exceptions?

Does that mean that advisers should never recommend an actively managed fund? Ultimately, it’s down to each adviser to make that call. But they need to remember that active investing is a zero-sum game. For every relative winner there’s a relative loser. So, statistically, they have to expect the fund they choose to underperform a comparable index fund after costs.

Of course, there are investors for whom achieving the best possible returns

is not the be-all-and-end-all. Even the late Jack Bogle, the most famous indexing advocate of all, once suggested that investors might want to invest up to 5% of their portfolio in individual stocks or active funds and see it as “fun money”. As long as the client is aware that it will probably leave them with lower returns, that’s a decision for them.

Other investors will want to invest all or part of their portfolio in a socially or environmentally responsible way. Again, fund management companies often claim that these sorts of investors are better off using active funds, but the jury is out. There are plenty of passively managed funds now with either a positive or negative screen or both. In any case, the record of passive managers on governance issues (in other words, holding company boards to account) is just as good as, if not better than, the record of active managers.

Luck, skill and risk

The final thing to remember is that when active managers do outperform, it’s often down to one of two things. The first is luck, and the second is the amount and type of risk they’ve taken. There are certain types of stocks — small-cap and value stocks, for example — which have been shown to outperform the broader market over the long term, albeit with a greater degree of volatility. In many cases, when a successful fund is analysed, it turns out they simply drifted from their stated style and overweighted small or value companies.

The fact is that clients don’t need to pay active management fees to capture these risk premiums. There’s a large number of so-called smart beta funds, or factor funds, available nowadays that capture them in a more in a more efficient and systematic way at considerably less cost.

Conclusion

In short, then, cap-weighted index funds are ideal as core investments. If you want to include an actively managed element too, the important thing is to prioritise cheap funds over more expensive ones. You may well find a suitable factor fund that’s cheaper still.