Price Gap Between Active and Passive Funds Continues to Grow

Anyone investing online regularly into an ISA or SIPP through a stock broker will most likely be aware of the ongoing debate around the relative cost of active versus passive funds. The latter, which reflect and track equities indices and don’t involve active stock picking, have risen hugely in popularity over recent years with both institutional and private investors. The reason why more and more capital has gone into passive tracker funds is that the historical evidence demonstrates that more expensive actively managed funds don’t actually often perform better than indices that cover a particular market or sector. That’s a combination of two factors. The first is that the stocks actively picked for managed funds simply don’t, in combination, deliver better returns than indices over the long term. The second is that any slightly better performance is neutralised by the higher fees.

The result is a growing body of opinion that most active fund managers do not justify the higher fees their investment vehicles come with. It might be expected that this would lead to active funds reducing their fees to remain competitive. However, according to a recent study conducted by investment research firm Morningstar, this has not actually proven to be the case. Rather, the opposite has happened. Passive funds and those without managers have continued to reduce the fees they charge over the past 5 years. And, while actively managed funds have also reduced costs, they have done so by less, meaning that the expense gap has increased.

The Morningstar research shows that investment funds without a manager have reduced fees by up to 50% over the past five years and passive tracker funds by 28%. Actively managed funds, on the other hand, have reduced the fees they charge those investing online by only 18% over the same period.

The bottleneck seems to be the kind of competition. Passive funds offered by different providers are essentially the same so compete against each other mainly on price. They also compete with the growing ETFs industry. Active fund managers have been accused of acting like a cartel and implicitly agreeing between themselves to avoid a race to the bottom on fees.

A 2013 ruling obliged investment funds to unbundle charges and list different fees separately. One of these fees is an ‘advice’ fee, which investors have the option to opt out of at a certain point. But many investors are unaware that they have the choice to move to a ‘clean’ version of the fund that doesn’t include these fees. And the funds keep charging it until investors ask to be opted out.

The actively managed funds sector will believe that the investment cycle will again turn in their favour as we enter a period of greater volatility and potentially the end of the long bull run. Passing tracker funds perform best when markets are going up. However, the sector is in danger of shooting itself in the foot if it doesn’t start to realise it is losing competitiveness and trust with questionable charging practises.