When deciding which investment vehicles to use for long term investing, the usual dilemma one has is whether to go for an actively managed instrument or a passive one.
A passively managed investment is whereby an investor gains exposure to a particular country, sector or commodity through an Exchange traded fund. ETFs are openly traded on stock exchanges with the aim to perform in line with a specific index (e.g. S&P 500) or commodity (like gold).
An actively managed fund invests in a collection of instruments the fund manger feels can outperform the index. (For instance, for a UK Equity Fund the index to beat would normally be the FTSE 100 index. This index includes the biggest 100 companies in the UK market). To identify companies where to invest in, fund managers analyze company fundamentals, meet the management and work to maintain a balance of good companies that will perform better than the market average in various market conditions. Unlike passively managed funds, these funds don’t track the movement of a particular stock market index.
Which one is best?
During the last couple of years, interest in managed funds has been declining in favor of ETFs with the main reason being fund manager fees. The common rationale is that investors don’t feel the need to pay an additional fee for something which can be easily achieved, at a lower cost, through the use of ETFs.
This reasoning is true in certain sense since it is becoming difficult for fund managers to outperform the markets and in variety of cases, passive investing generated better returns.
As we can see from the first image below, we compare a standard ETF (iShares Core S&P500) against one of the most prestigious fund managers (Schroders), both investing in US large cap stocks. Here we can appreciate that over the longer term, owning the ETF would have generated an annualized return of 16.4% against 14.2% for the fund (This is a difference of over 2% per annum which covers for inflation!).
Fund fees (0.07% vs 1.59%) surely had a drag on the performance apart from some bad managerial decisions which took place throughout the period.
Is this always the case?
We do need to pay attention however as this does not happen in every case and this is where we need to do our homework when picking financial instruments.
One of the major benefits of active management is that a good manager can be quick to react to take advantage of market movements and the portfolio composition is adjusted accordingly.
The second image below compares the same ETF (iShares Core S&P500) against another US Equity Fund – T.Rowe Price US Blue Chips. In this case, we can appreciate that owning the managed fund would have generated an annualized return of 18.8% against 16.4% for the ETF. Therefore, the active fund would have over performed the ETF by 2.4% each year!
By just looking at the chart, we can notice that the performance between the two was relatively the same up to early 2017, but from that point onwards, the manager made good decisions which resulted in better performance even though the manager had been charging the higher fee throughout.
There are some instances that owning ETFs make more sense whereas there are cases whereby mutual funds are more appropriate. In our next webinar we will be discussing the differences between the two and how you can pick the best from both. Click here to register for free!