What Are The Two Main Fund Management Approaches? Which Should You Choose?Fund Management Approaches Welcome to the third part in my overview of how a fund manager manages funds. I'd like to reiterate that for anyone to help their money management abilities, studying the work of the professionals is likely to help. Even if only a little. There is a group of investors who are of the opinion that stock picking is pretty pointless within an asset class. The argument goes that the market is efficient but that mispricing is likely between markets. This means that the big additional returns can be made by the asset allocation decision. I'm not saying that these thoughts are right or wrong. However, Warren Buffett has laughed at any idea of an Efficient Market Theory for years. His compelling response, is that if markets are efficient, why does he do so well by picking individual stocks? You can see his point... This leads to an obvious decision. Do you choose an 'active' or a 'passive' fund manager? Active Fund Management These managers spend their time looking for over or under priced assets and then altering their portfolios to take advantage of the situations. In other words, they are looking for 'mispricing' opportunities. This obviously increases potential risks. The manager may move the fund heavily into or out of one security or sector. The risk is then increased by taking on more mispriced assets. This can lead to larger gains or losses and greater levels of volatility. Managers may also be trying to 'time' their trades to maximise profits. We have all heard of the maxim to 'buy low and sell high', which in theory is easy to do. Fund managers on the other hand, are trying to do this for six selections at a time and taking into account all available information (including company, market or macro economic news). It really can't be easy. To put it into perspective, as easy as we may think all this is (or should be), only about 20 percent of managed unit trusts (in the UK) outperform the market each year. Passive Fund Management This route to returns has been championed over the last decade by the 'index tracker'. They are designed to mimic a financial market index. This includes the risk and return profile. To achieve this, a fund will choose a group of securities (usually a little less than the number in the index) and buy enough to weight the holdings closely to the levels in the actual index. By holding less securities than the index, some of the less influential holdings can be avoided and thus costs held down. A big factor in favour of index tracking is the low level of transactions (and therefore transaction costs) that are required. For example, if you were tracking the NASDAQ, you would need to hold a lot of Microsoft shares. But being such a big part of the index, you would not be trading into and out of Microsoft stock. Once the holding is in the fund, it is pretty much going to stay that way for a long time to come. There will be some obvious occassional adjustments, but nothing big. Oddly, an index fund manager is considered to be successful according to two main criteria. Firstly, the costs involved in managing the fund, the lower the better. This must be one of the few areas in high finance where low fees are considered to be a good thing! The second area relates to performance and is called 'tracking error'. This relates to the difference between the returns of the index and the returns of the fund. As you might imagine, the closer the index comes to matching the returns of the fund, the better. Since, much of the passive fund management process is 'hands off' it makes some sense to limit human intervention. For this reason, many major fund managers pass their decision making over to complex computer modelling systems. I'm not sure whether this actually reassures me or not. I imagine that we have all heard about the active sell programs that made the 1987 crash far worse than it needed to be. Whilst an investor may like the sound of this approach, the risk profile of the index in question should be assessed. If the market is too risky for you, using an index tracker will not make it any safer! As constituent companies change over time, the bias and risk profile of the market will change. This will also have an impact on the investment risk to an investor. Should the risk profile change too much, it would be wise for an investor to find new holdings with a profile to match. One problem is that many, if not all, private investors will not think about this, meaning that over time they may find themselves with unsuitable holdings and not realise. In investment, the risks always come home to roost sooner or later. This leads to an obvious downside to passive management. This is in a falling market. As nice as it might seem to be in a passive fund on the way up, who would want to stay in a fund that will track down? At least with an active fund manager, you know he (or she) is trying to do their best. I have no doubt that many investors will be holding at the wrong times and then find themselves tracking an index down. This always seems to be the situation. There is (of course) a 'third way'. Until a few months ago, the very words, 'portfolio tiliting' were a mystery to me. I discussed this subject in some depth a few months ago in my monthly letter, so won't do so again here. * This article was first sent to my newsletter subscribers in September 2006 * Would you like to increase your trading profits? You would? Then please click here to read about this excellent
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