The reasons why the active approach is still favoured include:
- By definition, a passively managed fund should underperform the index it is tracking because of transaction costs and management charges. Indeed, if a passively managed fund outperforms its index, this suggests that either something has gone wrong with the tracking process or the manager is involved in stock-lending, which involves counterparty risk.
- While some active funds do underperform the index, there are plenty of funds which do outperform. Some have done so consistently for many years.
- Indices are generally constructed according to the free market capitalisation of shares, so the largest companies have the biggest weighting, whether or not they are the most attractive investments. This can mean that the holdings of a passive fund are highly concentrated in a handful of companies and sectors. For example, in mid-November 2009, the ten largest companies in the FTSE 100 represented over 48% of the index. HSBC and Shell, the top two companies, together accounted for 17% of the index.
- Passive investment means being fully invested at all times, whereas the active fund manager has the opportunity to hold some of his or her fund in cash if the market is falling. Similarly, a passive fund has to take up an index constituent’s rights issue, even if the company is failing.
- The regular re-balancing in indices can be exploited by active managers who know that passive funds will have to buy and sell certain shares on specific dates to match the index revisions. This can mean the passive funds are forced to buy at inflated prices and sell at depressed prices.
- Passive funds generally have to follow an index, so if there is no appropriate index, there can be no passive investment option. Some categories of fund, such as absolute return funds, are therefore only available as active funds.
