Why choose active management?

“Can investment companies help me beat the stock market?” asks the investment website Motley Fool in a recent article. The short answer – as the author of the piece agrees – is yes. But it’s worth thinking about this ostensibly simple question in a little more detail: there is no guarantee any collective investment vehicle will outperform the market, but there is a good case to make that closed-ended funds have more potential to do so than other types of collective structure.

This is a debate that has divided people for many decades, with advocates of passive and active investment equally passionate about their cause. For the former, since collective funds charge fees, they start behind the stock market in any race – and those with higher fees may struggle to catch up; in which case, it makes sense to opt for cheaper funds that simply try to mirror the market. The latter, meanwhile, put their faith in the ability of the best fund managers to build portfolios of assets capable of delivering superior returns even after the impact of charges.

Still, that’s an argument about the merits of active versus passive management in any type of collective fund. Why would actively-managed investment companies stand more chance of outperforming than other active vehicles?

In fact, there are several reasons. Indeed, it is worth pointing out that there are almost no passively-managed investment companies. Some funds build portfolios that diverge from market indices and benchmarks more markedly than others, but almost all closed-ended funds are actively managed.

That’s a good starting point, and from there on, investment companies come with a number of advantages.

Cost is certainly part of the argument. For many years, investment companies carried significantly lower charges than their open-ended fund counterparts, largely because the latter paid sales commissions to financial advisers. Today, with such commissions no longer allowed, the playing field is more level, but many investment companies still offer lower fees. In other words, they give the stock market less of a head start.

Gearing is another important factor. Investment companies are unique in their ability to take on borrowing if the manager thinks doing so makes sense; in a rising market, an investment company that has borrowed additional cash to invest will see its returns accelerate more quickly. The opposite is true if the market falls, but if you believe asset prices are going to rise over time, gearing is attractive.

Then there is the question of choice. The structure of investment companies makes it easier for them to invest in illiquid assets – unquoted companies, property, infrastructure, private equity and more, for example. To beat the stock market – or to steer clear in difficult times – investors may need access to a broader range of assets; investment companies can provide that.

Finally, investment companies enjoy a structural advantage. The manager has a fixed pool of assets to look after. In an open-ended fund, by contrast, the size of the fund rises and falls as investors put money in or take it out. That’s an additional complication for the manager to juggle.

None of which guarantees investment companies will outperform. Ultimately, the key factor is the decisions that the manager takes about the portfolio. Disappointing investments will drag performance down whatever other advantages a fund might enjoy.

Still, almost every analysis of the long-term performance of investment companies reaches the same conclusion. In most sectors of the market, the typical investment company outperforms its open-ended equivalent over extended periods. That doesn’t mean it beats the market – but it certainly increases the chances.