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Active and passive funds - and missed opportunities

one month ago

Alex Burn, Investment Manager

Alex Burn, CFA,

Investment Manager, AXA IM Select

Active and passive funds - and missed opportunities

The popularity of passive investment funds, typically exchange listed index trackers, has grown steadily over the past decades. At $13.3 trillion, the total value of US passive funds at the end of 2023 topped the value of active funds for the first time. These funds offer investors simple and straightforward access to financial markets at a low level of fees. But research shows that the exclusive use of passive funds as an investment tool could lead to missed opportunities during certain periods when active funds outperform their benchmarks.

The aim of active funds

Firstly, let’s be clear on the differences between these two investment approaches. An active fund, which can be based on regions, sectors or themes, is run by an investment manager. This firm will use its expertise to identify inefficiencies in financial markets, that is to say points where assets appear to be wrongly priced. Recognising and seizing such opportunities for outperformance for an active portfolio is known as ‘creating alpha’. The fund manager will charge a fee to provide this service.

The aim of passive funds

A passive fund, however, will make no attempt to identify market anomalies. The strategy in this case is simply to replicate an index (such as the S&P 500, or a more specialist one, such as emerging technologies) as efficiently as possible. The passive ‘tracker’ fund will employ different strategies to do this, often through the creation of an Exchange Traded Fund (ETF). A fee is also charged for the passive service, but it is typically far lower.

An opportunity…

Our research has shown that opting to invest exclusively in passive funds might lead to missed opportunities, eroding some of the advantages associated with this investment style. This is particularly marked at moments of significant change in investor sentiment. As an example, let us look at two time periods. Between 2017 and the first half of 2021, passive funds largely beat their active counterparts, in particular the funds focusing on US Large Cap Equities, European Aggregate Bonds and Global High Yield Bonds. However, during the period beginning in September 2021, when central banks launched an aggressive interest rate hiking cycle, there was a run of marked outperformance by some active funds. The effect was most pronounced among European and Global Bond funds.

…is missed

Would an investor in a passive fund have been aware that such an inflection point had been reached in September 2021? That is unknowable but unlikely given that, by its very nature, the performance of a passive fund is always in line with the index. Whereas an investor in a top performing active bond fund would have been aware of considerable outperformance over recent years.

Architas view

Our view

It goes without saying that passive funds will always perform in line with their benchmark index because they replicate that index, meaning that both underperformance and outperformance are impossible. But it is also the case that periods when there is divergent performance against a range of active fund managers might not be obvious to a passive investor. Our research shows that at certain periods of market activity, the upside potential captured by the best performing active managers is missed by a purely passive investor. This means they lose an opportunity to make higher investment returns and increase their investable capital. At AXA IM Select we seek out investment opportunities among both active and passive funds, aiming to create a balanced and diversified portfolio.

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