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If you're looking for long-term performance, stick with passive funds

by , 30 June 2015

When investing in funds like unit trusts, you have two options.

You can invest in a passively managed fund, which aims to track its underlying index. Or you can invest in an actively managed fund, where the fund manager strives to beat the underlying market.

So which option is the best long-term investment for you?

Read on to find out…

How do actively managed funds perform?

Over the long-term, actively managed funds don’t perform well. They may show periods of outperformance, but over the years, the majority can’t keep this performance up.

So why don’t fund managers perform better?

There are different reasons…

Reason #1:
The first is the market is more efficient than many investors realise. This efficiency means that all available information, good and bad, immediately reflects in the prices of shares.

Reason #2:
The second is over-diversification, Alex Green in Investment U explains. Mandates usually state that a fund must own lots of different shares.

Holding many shares can protect a fund from the bad performance of a few shares. But it also protects the funds from the good performance of a few shares.

You can see the impact of holding a concentrated portfolio from looking at the likes of Warren Buffett. He holds a lot of money in less holdings. Of course, if you’re a good stock picker, this strategy can really work.

Reason #3:
The third is funds usually have to hold a certain proportion of their portfolio in cash. This means that there may be times when a fund manager has to sell out of shares to maintain this balance.

The other downsides of actively managed funds

But performance isn’t the only concern with actively managed funds.

They also charge high fees. For an actively managed fund to beat the market, it also has to factor in management fees and other costs. This is over and above the benchmark they’re trying to beat.

This is why, unless you invest in an actively managed fund that has superb long-term performance, your money is better off in a passively managed fund.

If you opt for passively managed funds, you can stick with unit trusts, or look to exchange traded funds as an alternative.

By sticking to passively managed funds, you’ll benefit from the market’s performance, which is generally better than a lot of actively managed funds. And the fees are generally less.

So there you have it. Why you should stick with passive funds if you’re looking for long-term performance.

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If you're looking for long-term performance, stick with passive funds
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