This article is taken from our FREE daily investment email Money Morning.
Every day, MoneyWeek’s executive editor John Stepek and guest contributors explain how current economic and political developments are affecting the markets and your wealth, and give you pointers on how you can profit.
Just a reminder – on the evening of 12 February, I’ll be talking to MoneyWeek regular and dedicated value investor Tim Price, and Netwealth’s Iain Barnes about where the key threats and opportunities lie in asset markets right now. We’ll cover everything from inflation and interest rates to political risks and the best global equity markets – book your place now.
Amid all of the forecasts for 2019, there’s one persistent forecast being made by almost all active managers: this is the year that you need good stock pickers on your side. This is the year that active management demonstrates its mettle, compared to passive funds.
Passive might have been fine in the easy money days gone by, but now you need a real live human manager on your side.
It’s intuitively convincing. Like many intuitively convincing arguments, it’s also nonsense.
The “Blur vs Oasis” of the financial industry
Just to be clear, I have nothing against active management. And I think it’s fair to say that investing against a backdrop of quantitative tightening (or money burning, as I like to call it) is going to be far less of a smooth ride than the days of money printing (AKA quantitative easing).
That does suggest that a simple “buy and hold” strategy – whacking most of your money into an index fund that tracks your local stockmarket – might not be the best way to save for your retirement.
But it never was. Which is why this whole debate is so frustrating.
I’ve talked about this before, but it can’t be emphasised enough: this whole “passive vs active” debate is the financial industry equivalent of the old “Oasis vs Blur” slanging match that readers who are roughly my age might remember from the 1990s. That was a false debate, cynically manufactured by the music industry to sell more records.
Same goes for “passive vs active”. Active managers have decided that the best way to fight back against the passive onslaught is to acknowledge that they haven’t done very well during the bull market, but to promise that they’ll do better in the bear market.
But there is no such thing as a “passive” investor. So if you feel yourself being swayed by this argument, then you need to take a closer look at your investment process and try to understand what’s going on here.
Clearly, if you are picking your own stocks, you are an active investor. But even if you only ever invest in tracker funds, you are very much an active investor, not a passive one.
When you are investing, here’s the rough process you should be following.
Assuming you have paid off all non-mortgage debt, and actually have spare money to invest (many people don’t, or are essentially stuck with whatever pension their employer offers), then you first need to think about asset allocation.
I like to keep asset allocation simple, so I split it into just five categories: equities, bonds, property, cash and gold (every other asset class, from hedge funds to mortgage-backed securities, are just variations on one or other of these classes).
Your mix will depend on your view of the world and on how close to retirement you are. And this process of asset allocation involves plenty of active decisions, even if you undertake it with the help of a financial adviser.
If the stockmarket falls, then an active fund probably won’t help you
Once you’ve decided on your asset allocation, you then need to think about how to implement that. Which equities are you going to invest in? Do you want to single out specific countries? Do you just want a split between emerging and developed markets? Do you want to put a “value” spin on that, or a “growth” one?
It’s true that if US stocks are going to go down, then anyone investing in an S&P 500 tracker is going to lose money. But so will most active funds that invest in US large-cap stocks. So the key is not whether you go active or passive – it’s about whether you decide to include the asset class in the first place.
So all of those asset allocation decisions are pretty active too.
It’s only once you’ve boiled it down to those sorts of levels that you can start talking about specific funds to buy. At that point, you can look at whether you should invest in an index tracker, a “smart beta” fund (a tracker which uses a specific strategy, such as investing in value or momentum stocks), or a fund with a human manager.
When you look at it this way, notions of “who does best in a bear market?” are basically irrelevant. Instead, you want to find the investment instrument that gives you the most effective exposure to the asset you are trying to invest in.
And this is where costs come in. You can’t control the future. You can look back and see if a potential fund choice has achieved what it sets out to achieve in the past, but you have to remember that you can’t guarantee that this will continue.
However, you can control what you pay for a fund. And this is where the advantage of going for the passive option usually comes up. If you can’t time the market perfectly and you don’t know what’s going to happen next (clue: you can’t), then you are almost certainly better off going for a fund that will take 0.1% of your annual returns rather than the one that takes 1%.
Active management definitely has a place. There are lots of good investment trusts (you can check out some of our favourites in the MoneyWeek investment trust portfolio). Some of them even do a good job of handling a lot of that asset allocation process for you.
But my core point is this: if you think this is going to be a tough year for your passive portfolio, don’t imagine that swapping into actively-managed equivalents is going to make it any easier.
If you really are concerned that we are heading into a bear market, and that’s keeping you awake at night, then what you need to look at first is your asset allocation – it’s probably too aggressive.