There is a longstanding debate as to whether an actively managed fund can offer any additional benefit to investors compared to a passively managed index tracker.

Critics of active management argue that such funds are unlikely to consistently outperform their benchmark and are therefore not worth the additional charges.

However, new data from FE Analytics has shown a properly active managed fund will outperform its FTSE All Share linked passive counterpart over the long term.

The philosophy of an actively managed fund is based upon the ‘modern portfolio theory’, which originated in the middle of the last century. This is the premise that a portfolio comprised of a diverse spread of imperfectly correlated assets can provide high returns with the least amount of volatility.

A key aspect of this theory is the idea of the ‘efficient frontier’. Essentially this works by plotting the risk/reward profiles of different portfolios in the form of a graph. This can then be used to deduce the best return that can be expected for a given level of risk. A rational investor will only ever have a portfolio which lies somewhere on this frontier. An active fund will operate in accordance with these principles and aim to consistently outperform the index against which it is measured. It will employ a professional manager to take responsibility for all investments and decide the appropriate time at which to buy or sell securities.

The cost of the manager’s expertise will be in the form of an annual charge of between 1.5 and 2 percent. If a manager fails to achieve a sufficient level of out performance against the benchmark then these charges will erode the value of the investment.

Conversely, the rationale behind passively managed funds is the ‘efficient market hypothesis’. This was developed in the 1960s and states that the price of a given security will always reflect all available information about that security. It is therefore not possible to outperform the market by trying to identify undervalued stocks, in the way that an active manager would try to do.

There is much evidence to support this hypothesis. For example historical performance data or a company’s public financial statements can offer little advantage to investors. Rather than trying to beat the market by stock selection some believe that it makes more sense to accept the average level of returns offered by a passively managed fund.

The majority of passive funds are tracker funds that follow the movement of the index to which they are linked. Many tracker funds offered by UK investment companies will be linked to the FTSE All Share, which comprises all the companies listed on the London Stock Exchange.

Passive managers will emulate the market in one of two ways. The largest funds will have sufficient assets to enable them to fully replicate the market – for example a FTSE 100 tracker would buy shares in all one hundred companies in accordance with their market capitalisation. Smaller funds will purchase a sample of shares, representative of the market as a whole.

The fortunes of passive funds are therefore entirely dependent on the performance of the market to which they are linked. They will always underperform the market by the amount of their operational costs – typically up to one per cent per year. Exchange Traded Funds have been available in the UK since 2000 and operate on a similar basis.

Advocates of passive management will point to the fact that many actively managed funds are unable to consistently outperform their benchmarks. Ultimately this means that investors will be paying a considerable annual charge for no conceivable benefit.

An analysis of the UK All Companies sector as at the end of 2010 showed that less than a quarter of all actively managed funds were able to outperform the FTSE All Share over the previous decade.

However statistics such as this should not be used as a reason to eschew the active managed sector entirely. Instead it just emphasises the importance of choosing the correct fund.

There are a number of skilled fund managers who have excellent track records and have consistently achieved returns in excess of the market. A skilful active manager should be able to achieve a positive return for investors even during periods when markets are falling.

* Trevor Law is a director with Merito Financial Services, chartered financial planners, based in Solihull.

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