Historically, most private investors would invest through a fund manager. In this way, you would pay an annual percentage fee to an investment institution to actively manage your investment i.e. make the buying and selling decision on your behalf.
The aim of investing in managed investments is to generate better investment returns than the stock market index as a whole, or another appropriate benchmark.
Discretionary investment is a specialist branch of managed investment whereby the manager has a greater range of investment powers and freedoms to make buying and selling decisions without your consent (although always within with the remit and investment powers that you grant at outset).
Over recent years there have been numerous studies to suggest that many fund managers do not achieve their aims of beating their respective benchmarks, and it has led some investors to favour a “passive” investment approach.
Passive or index trackers
Passive investment does not employ a fund manger to make decisions, and instead of trying to outperform the market, you simply ‘buy’ the market as a whole. For example by investing in an S&P 500 tracker, you would effectively be purchasing the top 500 shares in the US stock market.
The key difference between the managed style is cost i.e. whereas a manager may charge between 1-2% per annum to manage your fund, you can access a tracker fund from as little as 0.1% which can make a huge difference to your fund value cumulatively.
Proponents of this approach accept they will only even achieve the return of the market as a whole (with no outperformance) but because you are spending far less in fees, believe they will do better over the longer term.
Proponents of active management on the other hand highlight the drawbacks of the passive approach viz. in a falling market, you will only ever track a falling market, tracker funds “blindly” sell what may otherwise be high quality investments at inopportune times, and that tracker investments can still be complex to understand, such as the difference between ‘synthetic’ versus ‘physical’ tracking methods.
Summary – balance pays
As my previous two articles have demonstrated, tax and investment planning generally involves shades of grey, rather than black and white solutions and in practice we do not believe either approach is the ‘holy grail’.
Rather each management style can offer benefits within a balanced portfolio. Holding passives can reduce the overall cost of your portfolio (thus increasing your net return) and using managed funds can complement by avoiding “blind” automatic sales and potential downside mitigation.
Whichever route you choose, minimising fund fees is crucial as it is the biggest eroder of returns over time.