Active vs Passive vs Robo Funds: Which is Best?

There used to be just two approaches to investing your money. One would be to pay a manager to do it on your behalf. You'd usually pay them a very good fee, normally around one to two percent of the assets under management and then they'd invest it on your behalf with mixed results. On the other hand you'd have a passive fund here you can track an entire market very cheaply but it wasn't a very smart approach and if the markets crashed you had to follow the market down.

More recently the rise of Fintech has enabled algorithms to do the same job as a human manager and this sits somewhere in the middle between actively managed funds and passive funds. But this new approach hasn't really been around long enough to tell how successful it will be. Usually it takes a couple of financial crises in order to work out whether a technology is worthwhile or not so really the choice is very much dependent on your personality but also your investment goals and who you trust. So let's find out a little bit more about Robo advising versus active funds versus passive funds.

​The choices in the past were limited to active funds which were managed by humans and tended to be very expensive and often the performance didn't justify the fee. The alternative was to use a passive fund: you strip away the expensive expert and his Lamborghini and you follow a whole index like the FTSE 100 up and down.

Here you can see the two extremes in terms of costs the cheerleader of the passive approach has been Vanguard. The cost on one of their equity trackers in the United States is just point zero seven percent so if you invest a hundred pounds in that fund you'd only pay seven pence per year in management fees on the other hand the average hedge fund would charge you £1.40. The question is whether active funds actually justify their fee.

​Standard & Poor's is a US company which produces indices and they have a website which specifically tracks the performance of fund managers versus passive funds. Can they really justify their fees and beat the index? In the United States it certainly seems as if they can't. Over a five-year horizon the SPIVA website finds that ninety two percent of the funds underperform the index. In Europe the performance is a bit better: "only" eighty percent of the funds underperformed their index but S&P finds that the longer the horizon over which you track these active funds the less likely they are to outperform the index. And that suggests that it's just luck rather than skill which determines whether they outperform and nobody wants to pay someone for just being lucky rather than being skillful.

​Recent poor results for active funds have certainly favoured the passive approach to investing. You don't have to look far in any newspaper in order to see headlines like this. Funds such as Vanguard which promote the cheap passive approach to investing have simply been hoovering up the cash in 2016. In the U.S. there's been a stampede of money out of active funds into passive funds. But passive funds aren't perfect. The difficulty is that you're handcuffed to the market. In 2008 during the Global Financial Crisis the S&P 500 fell by 56%. If you'd invested in a tracker which lost only 46% your passive fund manager would have been overjoyed because they'd have beaten that index but that's really not a success. Ideally we wouldn't have lost any money despite the crash.

​A new breed of computer algorithms have enabled a third way. As well as active and passive we now also have Robo funds. Instead of having a human or markets in charge now we have a robot. Robots don't drive Lamborghinis or live in Knightsbridge so in theory these Robo funds should be run cheaply, but they haven't really been around long enough to determine how well they perform in all market environments including in a crisis.

​So how do the fees compare? In between the passive Vanguard fund and the average hedge fund I've put one of the most popular Robo funds which is called Nutmeg, in particular their fully managed fund. For investments of up to £100,000 they charge 0.75% so on a hundred pounds you pay 75 pence a year that's still well above the Vanguard fund, almost ten times as much, but you can bet that as the novelty wears off and there's more competition in this market that fee will reduce.

​So let's introduce some terminology. Passive funds are also called beta funds. If a fund's beta is one it perfectly tracks the index up and down, here I've show the S&P 500. For a fund where beta was one you'd be looking exactly at the returns of the fund. So beta strategies are market tracking strategies. Alpha, on the other hand, produces a steady and smooth income regardless of recessions or market crashes. These are also called absolute return funds because they don't care what the market does they always produce a positive return, at least in theory. So instead of tracking a market we have pure mojo. Unfortunately after the Global Financial Crisis it seems like alpha is a matter of faith, almost like belief in aliens or possibly unicorns. And the number of adherents in that faith has fallen dramatically.

​The reason why we introduced the terms alpha and beta was because many of the robo funds are called "smart beta" funds. Passive funds are often considered to be dumb so the advent of new algorithms put the smart into beta and the idea is that you get some outperformance relative to the index but at a cost which is comparable to passive funds.

​Smart beta comes in many flavours. Some are specific to equity funds only. One form of smart beta is to go for high dividend yield stocks, another is to go for value in other words you buy cheap stocks and over the long term these are supposed to outperform and as a measure of cheapness you can use price-to-earnings or price-to-book value. Another factor that performs well over the long term is the size of the company. Generally, small stocks tend to outperform over very long periods of time, so by selectively choosing small companies with low market capitalization your fund is likely to outperform.

If you mix together multiple asset classes like shares and bonds there are also some smart beta strategies that you can employ. One of the most powerful is a momentum strategy: you simply choose assets which have the greatest price momentum in other words their price is rising most quickly over some period of time. Or you can choose assets which have lower risk in other words their daily price variability, up and down, is very low. Despite taking a lower risk, over the long term such strategies can perform quite well. Or instead of going for a 60% equity 40% bond portfolio you combine your assets such that each one contributes an equal amount of risk. Generally this means less equity in your portfolio and more fixed-income. Bonds typically have a much lower risk than equity so some of these funds actually borrow money to boost the risk and the return of the bonds in the portfolio relative to equity.

​Here are a couple of examples just for illustrative purposes remember this is not a recommendation. This fund by Amundi is based on European shares but instead of buying all the shares in the index as you would for a passive fund it chooses a subset of the shares and it does so in such a way as to reduce the volatility, or the risk, of the investment.

​Again, for the purpose of illustration, here's a fund that mixes two smart beta approaches: it combines both high dividend or high income with low volatility. So this fund has been constructed for investors that want high income combined with low-risk by combining these two smart beta approaches.

​I presented it as being very clear-cut but of course in reality you can have a mixture between a robot and a human approach. You can think of this as a fund management equivalent of a cyborg. Computers and humans have different strengths. For example when you're diversifying a portfolio you have to think about correlations between assets. If you have just 20 assets that you're combining you have to consider hundreds of correlations and humans just can't do that well whereas computer programs can. On the other hand, it's very hard to program a computer to understand political risk. How would you teach a computer about something like Brexit, or Marine Le Pen?

​So the solution is to have a robo fund but with a human overlay: sometimes the humans step in to adjust the portfolio weights based on their judgments about political or macro economic risks and hopefully the combination of the two is better than either alone.

​How does one of these Robo funds work in practice? First of all they assess your risk tolerance then once you put your money into the fund they match your risk tolerance with a portfolio. If you have a higher risk appetite you'll have a tilt towards equity. If you have a lower risk appetite there'll be a tilt towards bonds. And nowadays instead of having a fund manager at the end of a phone we expect to have a fancy app so that we can track the performance of our fund. At the bottom of the screen I've shown four Robo funds and this is the general process by which they all operate.

​Which of the three approaches is best? It really depends on your preferences. If you trust human experts and you're willing to pay for them and also you have a faith in human generated alpha then active funds may be best for you. If you want complete control of your money and you don't want to pay someone else to do it for you then creating your own asset allocation portfolio based on passive funds may be the best approach but this requires a great deal of self-discipline. If you like technology and you're an early adopter but also if you trust algorithms to manage your money which, again, is a matter of faith, then Robo funds may be the way to go.

​Remember this is not a recommendation for the choice of active, passive or Robo funds seek independent financial advice your IFA will give you advice tailored to your specific circumstances. And would you let a robot manage your money? We'd love to know! Tweet us @PensionCraft message us on Facebook, and if you like our videos subscribe to our YouTube Channel.

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March 12, 2017
ramin

Investment coach, financial author and founder of PensionCraft. Ramin wants to share his knowledge of how to succeed in long-term investment by keeping fees low, understanding behavioural investment pitfalls, knowing how to read macroeconomic indicators and understanding and controlling risk.