In my last article I wrote that I prefer to buy funds rather than invest in individual shares and finished with the suggestion that there is a school of thought that believes active fund managers do not provide any value so investors may as well pay lower annual charges and get an average return. So is there any benefit in doing this?

Passive Investing

Passive investors are those that believe the charges for an actively managed fund are too high (typically between 1.5% and 2% pa) and do not provide any long term value because the average fund manager fails to beat the index in which he/she is investing in (the FTSE100 or S&P500 for example). Instead they believe that index tracking funds that have annual charges as low as 0.15% provide a better long term return.

Index tracking funds hold every share in a given index and so the fortunes of the investment is directly correlated to the performance of the index.

Active Investing

Advocates of active investing, on the other hand, state that passive investing ensures underpeformance after charges relative to a stock market index. They believe fund managers that take active decisions do provide greater long term returns and with less volatility because the expert fund manager can make informed decisions on which companies to avoid and which to buy using the resources available to them.

I believe that there is actually a middle ground, that there is a case for both investment styles within your pension, ISA or unit trust portfolio. There are some markets where it is very difficult for any fund manager to add value because the market in which he is investing in is very efficient; there is a lot of information widely available and so opportunities to invest in companies that are unknown or unseen by others is rare. A good example of this type of the market in the US; it is easy for investors to gather information on any company and to buy or sell shares.

On the other hand markets such as the emerging markets and the Far East provide expert fund managers the to chance uncover information about companies that may be missed by other investors. This allows them to steal a march and buy in early at a low share price (or sell early at a higher price). Equally, within Europe an active fund manager can decide to avoid certain economies (Greece, Spain and Italy for example) but invest in others (Germany, France and Scandinavia) whereas the peformance of an index tracking fund will be influenced by the performance of shares in companies in all Eurozone economies.

So, at risk of sounding like I am sitting on the fence, it is worth paying the higher annual management charges for funds in certain regions but in others you are better off simply replicating the performance of an index for lower annual costs. But, if you are opting for active managed funds you will need a research process that determines which funds provide consistent returns without taking too much risk.