Pádraig Floyd explains the difference between passive and active investments
IF YOU READ NOTHING ELSE, READ THIS…
- Passive and active management are simple concepts to understand. Don’t be afraid of the language.
- Most defined contribution (DC) default funds will be passive arrangements to offer low-cost access to investment markets.
- Active management can provide higher returns but is not typically used in defaults because it is more expensive. It also requires more investor oversight
Now the auto-enrolment project has begun, millions of UK workers will automatically join their employer’s pension plan in the next few years.
The vast majority of members (more than 80%, according to figures from the National Association of Pension Funds) will not engage with their investments and will be placed into a default arrangement.
However, defined contribution (DC) schemes place the investment risk on the employee rather than the plan sponsor, so employers will have a moral, if not yet statutory, duty to ensure investments are suitable for members.
A default fund is simply the fund or mix of funds in which scheme members are placed if they do not make any investment choices.
Discussion of pension investments often involves an old argument of passive versus active management. While this may seem complex at first, the distinction is simple.
Actively managed investment funds are run by professional fund managers who make all the investment decisions on the member’s behalf. Using market research, analysis and their own instinct, they determine where they should invest the money they manage.
Their objective is to deliver a return that is greater than the average return from the market they are investing in. The argument for active management is that the manager may, within certain restrictions, move the money around to maximise return and minimise loss.
Passive management simply tracks a market. In the case of a passive FTSE 100 fund, the manager will replicate that fund. So, if ABC plc represents 30% of that index, it will hold 30% of the fund in that company’s shares.
Active management will typically cost between 1% and 2% a year, against a passive management fee of as little as 0.1% to 0.5%.
To be meaningful, a manager’s performance should be considered as the return it has delivered once fees have been deducted.
Many argue it is impossible for managers to beat the market, so the costs of active management are unjustifi ed. Passive management is much cheaper because once set up, the fund merely tracks the performance of an index, which is why passive funds are referred to as index or tracker funds.
Picking the right active manager may deliver excess returns, but it requires engagement of the magnitude not possible through DC pensions, where four-fifths of members refuse to engage with the scheme.
So, the vast majority of default funds will be passive investments because they deliver low-cost access to investment markets. As they replicate the market, they cannot protect the member from excessive volatility and this is why some sponsors are looking to introduce additional elements, such as diversifi ed growth funds and target date funds.
DIFFERENT STROKES
A small minority of schemes offer no choices at all through their default, the most high-profile of which is Whitbread. It has removed the choice of funds while members are in the growth phase so that it may control investments to deliver performance that encourages staff to stay in the scheme, by delivering consistent positive returns.
To do this, Whitbread has elected an actively managed growth fund and will use a passively managed pre-retirement fund for those approaching the end of their working lives.