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- Passively managed default funds are set up to track various indices, for example the FTSE 100. The fund is managed by a computer program linked directly to the stock market that is being tracked.
Employers must decide whether an active or passive default fund is best for their DC pension scheme, says Tynan Barton
Choosing between an active and a passive default investment fund for a defined contribution (DC) pension scheme puts employers in a dilemma: are they happy to put all their 'nest' eggs into the one basket of a passive fund, or are they willing to invest in the multi-assets of active funds?
Each type of fund has its advantages and disadvantages. Passively managed default funds are set up to track various indices, such as the FTSE 100. The fund is managed by a computer program linked directly to the stock market that is being tracked.
Actively managed funds involve human intervention and aim to outperform the indices. As such, they perform better in volatile markets because they can react to unforeseen circumstances and invest in the best underlying companies.
Mark Thompson, investment director at Prudential, says employers should consider that each fund appeals to different investors. "When you think of passive, it is increasingly global equity funds passively managed, and when you think of active, it tends to be more multi-asset diversified growth funds."
One key advantage of passive funds is that because they are linked directly to the stock market, they give the investor a degree of certainty. They also cost less because they do not involve many people, just a computer. They can also react quickly to market events. Mark Bingham, partner at Secondsight, says: "Whether it is good or bad, it reacts quickly. Nobody is stepping in, saying 'what do we think is going to happen here based on our experience?' Because a computer does not have experience, it has a program that tells it what to hold in each stock."
But a downside of a passive fund is that if it is tracking the FTSE 100, for example, it will include all stocks included in that index. This takes away the investor's control of the companies they are investing in. Julian Webb, head of UK DC at Fidelity, says: "If you look at the market crash of a few years ago, a member may not have chosen to have exposure to the banking sector, but because it is a significant part of the FTSE, they automatically had bad exposure to banking stock."
Active management
One advantage of an active fund is that in the medium to long term it should perform better because of the active management component. "It also means you are giving discretion to that fund manager, so they are the expert," says Webb. "They are acting on your behalf, and are trying to invest in what they see as the best markets and the best underlying companies in those markets."
Also, because the manager is taking a view in an active fund, the funds would not track the market all the way down to the bottom. Webb says that after recent market volatility, people recognise passive funds have an asset risk because they are pure equity funds. "You are only investing in one asset class. So to avoid volatility, trustees and employers are now saying, 'we do not want to expose our DC members to just one asset class; we want them to also invest in property, bonds, cash and commodities, to spread the risk around'."
The human factor in active funds has its pros and cons. Besides increasing investors' fees, employers must bear in mind managers are not infallible. "A perceived advantage of active funds is human intervention," says Secondsight's Bingham. "But other people say that one of the disadvantages is human intervention. It depends whether you think fund managers are good or not. If fund managers use their brain, and are lucky from time to time, it is not difficult to imagine an active fund will outperform a passive fund. But humans are not always right."
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