One of the great debates concerns the merits of active as against passive fund management. What do these phrases mean?
Managers of active funds attempt to outperform a market index by hand picking the securities which they think will perform best. They may use a 'top down' approach which tries to spot the sectors which are likely to outperform the market as a whole, or a 'bottom up' approach which concentrates on finding growth shares irrespective of sector.
Managers of passive funds create a portfolio that replicates the constituent shares of a chosen market index (e.g. FTSE100, FTSE250, FTSE All Share) and their weightings in the index. Such funds are called 'index trackers' or 'trackers' because they track the index.
In practice it is difficult to replicate the index exactly because the relative market capitalisations of the companies that make up the index are constantly changing. To get round this, the fund manager may adopt 'stratified sampling' techniques (sampling shares that behave like the index itself) and 'optimisation' techniques that attempt to identify the optimal portfolio that minimises tracking error and transactions costs.
Which is best - active or passive?
Supporters of passive funds point out that most active funds underperform the market as a whole. Individual funds will outperform the index, they say, but they cannot be identified in advance. Accordingly, active analysis is seen as an expensive luxury and tracking the indices is claimed to achieve better long-term results and lower charges.
Active fund managers argue that tracker funds always overpay for new entrants to the index and undersell shares displaced from the index because new entrants are bought only after the shares have risen in price, and departing shares are sold after their prices have fallen.
This phenomenon was borne out when the high tech speculative bubble promoted a number of New Economy companies to the FTSE100 only for some to be relegated again after a quarter in the premier league.
Critics of index trackers also argue that merger and acquisition activity can concentrate share holdings, making the funds less diversified, riskier and potentially in breach of the EU diversification rules.
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