If you're thinking about using funds to manage your assets, you want to know how exactly that works.
Active vs Passive
One of the benefits of using funds is that you don’t have to choose the underlying assets that are in the fund – the fund management company does that. And it does it in one of two ways:
Active Management – A manager and a team of analysts weigh up the perceived benefits of each possible asset in their universe and make a value judgement about whether to buy it, sell it or hold on to it.
So, let’s say you have fund which is a UK FTSE250 fund. The FTSE 250 is an index of the companies in the UK ranked from 101 to 350 in terms of their size as measured by the combined value of their shares. The fund manager in such a fund has 250 companies’ shares to choose from.
She and her team will analyse the companies and decide which of the companies’ shares should make up their portfolio. They’ll actively decide to buy some shares, discard some others and end up with what they believe to be the optimum collection of shares from the options they have available.
Then we have Passive Management – here, rather than choosing which of the 250 available companies to buy or sell or whatever, the fund aims to track the FTSE250 index by replicating it, usually by buying all 250 shares in the right weights.
By removing the need to make any decisions about which stocks to buy, they can dispense with much of the department of analysts and the very highly-paid fund manager which radically reduces the costs of a passive fund versus an active fund.
Here’s the kicker – there’s a weight of evidence that very few active managers consistently add value over and above their market. Think about it: if you’re going to pay a manager to choose which FTSE250 shares to buy, you want them to make you more money than they cost you in fees, so you would want to outperform the FTSE250 itself by at least the value of their fees. If they don’t achieve that, then you will have been better off just tracking the index.
Each camp will have it views on this, but I’m going to put my flag down here – I believe that most ordinary investors are better served with passive investments than active ones. When it comes to investing, there are very few things we can control.
We can’t control the economy, or the Coronavirus pandemic, or the governments or central banks of the world powers. But we can control costs, and what we can control, we should.
Especially when the evidence is, to my mind at least, overwhelming that most managers don’t consistently add value. Some do, but very few, and finding the ones who do is an added layer of work and research you’ll need to do. As a self-confessed lazy-ass investor, I opt for passive investment every time.
Whichever you go for, there is one thing you need to be careful of – drift.
Drift is Dangerous
When investing, you need to beware of DRIFT, which is the inexorable process of things getting out of kilter and increasingly so over time. We’ll talk more about asset allocation next week, but let’s say you set up an investment which starts out at 50% shares, 50% bonds.
Let’s say those equities go up by 10% a year – nice work, and the bonds only go up by 2%. After ten years, that’s not a 50:50 portfolio any more, but is now two-thirds equities, one-third bonds.
Now it’s heavily weighted to equities, so if they have a tough time, it’s more likely to be it’ll be more volatile than a 50:50 portfolio – its whole essence has changed. After 20 years, it becomes an 80:20 portfolio in favour of shares. If at this point you’re on the edge of retirement and there’s a massive crash, your portfolio is much more exposed to that.
It is vital to review any portfolio that you build, however it is made up. The review process is there to keep things in their proper place, to make sure nothing untoward is going on and more than anything to make sure that everything remains suitable for the reasons you set it up in the first place. Beware drift – be intentional by keeping your portfolio under regular review.
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