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Active tense

Understanding the key differences between passive and active funds is important in a sideways flat market

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I recently read that an actively managed fund could be a riskier investment than a passive fund in these uncertain times but that passive funds may not offer me the returns I need. What are the benefits and downsides to investing in active and passive funds?

The thing about the passive versus aggressive argument is that, depending on the market, you will have periods when one performs better than the other. Right now, you could argue we are in a period when passive is not performing as well because it is a stockpickers’ market.

In markets, you often reach an inflection point when trends move in the opposite direction. In those instances, an active manager can benefit from rebounds because they can see stocks which are unvalued and that is an investment opportunity.

If you pick a good active manager you may find your investment significantly outperforms the market and a manager who outperforms will carry on doing so, compounding the outperformance by effectively reinvesting that out performance and adding to your portfolio.

But critically, you have to understand what that active manager does. You may get a manager outperforming his own benchmark but, depending on his sector, he may not be doing very well even though he is fulfilling his mandate. And you have to be aware that there are also a lot of dog funds out there, so it is actually hard to pick the right fund manager.

The obvious benefits of a passive fund is that it will always be cheaper because it just tracks the index. Also, right now you can drive a bus between the different expectations of where the economy going to go. Without a consensus, you get volatility in the markets. From a passive point of view, it does not matter because you are tracking the index and you will just track it going up and down and it may not hurt your inv-estment, so it is a safe option.

There are some very good active managers with one view on where the market is going and others with an opposite view. They cannot all be right so in this climate some active funds might get caught out.

That volatility means you may get a bull run and you would miss that with a passive investment.

Thanks to the charges a passive fund takes, it will always underperform a benchmark of an index, so over periods of time your passive funds could potentially significantly underperform an index.

If you are not sure where markets are going to go, there is the potential of using an absolute return fund is a way of providing diversification and downside protection.

What would you rather do in a sideways flat market, as we have right now? It makes sense to go for an active manager because you want someone who can pick the firms who will do well, whether the market goes up or down, and a passive fund will not do that, they will just track the market, minus the charges.

Adrian Lowcock is senior investment adviser at Bestinvest

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