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Industry Insights Series Q2 2020
Alex Macdonald, Financial Adviser
Here at GDA Financial Partners, we are big believers in active fund management, as opposed to passive fund management and this blog sets why we hold these views.
Passive fund management
Alex Macdonald, Financial Adviser
Here at GDA Financial Partners, we are big believers in active fund management, as opposed to passive fund management and this blog sets why we hold these views.
Passive fund management
This centres around reducing the cost of investing and on
the face of it appears to be appealing, but this is achieved by eliminating
fund managers, investment research professionals and having no contact with the
companies in which you invest!
A passive fund will be ‘benchmarked’ to an index, with
stocks selected according to their size relative to the index (e.g. if BP’s
market capitalisation is 6% of the FTSE100, then the passive fund will hold 6%
of BP, irrespective of quality or the attractiveness of the share price).
This approach can be likened to investing in ‘the good, the
bad and the ugly’, as there is no attempt to differentiate each stock by taking
factors such as value (is the share over-priced), sales growth, debt, dividend
growth and recurring income streams, to mention only a few.
The FTSE100 Index is particularly vulnerable to passive fund
under-performance, having six major banks, two huge oil companies, four utility
companies and eight mining stocks, to name but a few of the sectors which the
prudent investor would currently wish to avoid.
A passive fund can only attempt to match the performance of
the index, never beat it and after the paying the fund annual management
charge, always under-performs the index!
Active fund management
This involves employing a fund manager (sometimes a pair or
team) who look at each stock on its merits within the given area the fund
invests (e.g. Europe or UK large cap stocks), assessing the share’s growth
prospects, whether it can be purchased at an attractive price and taking into
account the following factors:
- Is the current dividend well covered by reserves?
- How likely is it that the dividend will be cut (this would depress the share price and reduce future dividend income, a double whammy and is a big concern at present with companies’ finances under severe pressure due to Covid 19)?
- Are debt levels too high (such companies fare badly in recessions or downturns)?
- Is company news flow positive or negative?
- Are there taxation policies or impending legislation which would affect the future share price (e.g. a profits tax, mis-selling fines or compensation)?
As you can see from these points, investing
in a company without researching any of the above matters can only be deemed a
gamble.
Obviously there are good, mediocre and bad
active fund managers and our job as advisers is to recommend managers whose
track record speaks for itself and we look for consistent out-performance of
the sector average over the medium term, as this demonstrates that the stock
selection process used is effective.
Say a fund has a value of £1000 and the market falls by 25%, it is now worth £750. To get back to £1000 requires a gain of 33% (£250/£750 x 100) and this may take several years!
Far better not to lose 25% in the first place!