Thursday 14 May 2020

Industry Insights: Active Fund Management



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


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:

  1. Is the current dividend well covered by reserves?
  2. 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)?
  3. Are debt levels too high (such companies fare badly in recessions or downturns)?
  4. Is company news flow positive or negative?
  5. 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.

Preventing loss of capital by using active fund managers is important, as the following example shows: 

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!