Tom Bailey Column: Help! I believe in passive but buy active funds

Despite believing that passively buying the market is the best approach, our ETFs editor explains why he also has investment trusts in his portfolio. 

My view is that passive index funds and exchange-traded funds (ETFs) are a better way to invest rather than picking actively managed funds. That’s not just because I am the ETFs editor at interactive investor. I genuinely believe that the best way for investors to build wealth steadily and reliably is through tracking the stock market, rather than trying to pick their own shares or paying an active manager to do it for them.

There are two books which did the most to convince me of the theory behind this: Burton Malkiel’s A Random Walk Down Wall Street and Peter Bernstein’s Capital Ideas: The Improbable Origins of Modern Wall Street. It is hard to read either of these and not walk away at least half convinced by the “Efficient Market Hypothesis”. Simply put, this is the theory that share prices reflect all available information, meaning the market is efficiently priced. As a result, trying to beat the market by picking stocks is usually a futile exercise.

Other classic books on the subject from the likes of Jack Bogle, the late founder of Vanguard, also make a convincing case for passive. Bogle’s main argument was that the higher fees active funds charge compared to index funds add up over time and eat into returns. While you can’t control how your investments perform, he argued, you can control how much you pay for them.

On top of this, many financial data companies such as Morningstar and S&P now provide regular scorecards on how many active managers are beating their benchmark. The results vary but, for the most part, the majority of fund managers in developed markets fail to beat their benchmark over both short and longer-term time periods. Some active fund managers do outperform, but it is almost impossible to identify them advance.    

• Active versus passive: a brief introduction
• Three reasons not to use the Dow Jones index
• The cheapest ETFs to track global markets at the start of 2021

Yet despite all this, although most of my portfolio is held in ETFs, I also own several active funds. Am I failing to practise what I preach? Maybe. But here’s why I still have some active funds.

I’d like to think the active funds I own provide the type of exposure that passive funds cannot. If you take as your starting point wanting exposure to a certain asset class, sector or part of the market, the question that follows is how do you get access to it. Now, for the most part, an index fund might be the best option. But sometimes there isn’t an attractive passive fund to go for.   

So, for example, last year in the depths of the Covid-19 lockdown and Brexit no-deal fears, I decided it was time to get some exposure to UK micro caps. I’ve long been convinced by fund manager Gervais Williams’ thesis that very small companies are better at navigating tough times. I’d been persuaded of this by another book: The Future is Small: Why AIM will be the World's Best Market Beyond the Credit Boom, authored by Williams. 

But how are you supposed to get exposure to UK micro-cap stocks? There isn’t an ETF tracking AIM stocks. You can get exposure to small caps through the iShares MSCI UK Small Cap ETF (LSE:CUKS) – and that’s not a bad ETF to own. But Williams’ thesis is about much smaller companies. The only way to do so is with an active fund. So I opted for Williams’ own fund, Miton UK Microcap (LSE:MINI). Maybe I fell victim to an active manager talking his own book (quite literally), but the returns have been pretty good since I purchased it.

Another active fund I have is Mobius Investment Trust (LSE: MMIT). This trust invests in emerging and frontier markets and is led by two former managers of Templeton Emerging Markets trust (LSE: TEM), Mark Mobius and Carlos Hardenberg.

The trust’s focus is on small-cap companies. It is possible to track emerging market small caps, but I think this part of the market is much less efficient, at least for now, due to being less widely researched and followed compared to developed markets.

• The Tom Bailey Column: Dax 30 rule changes get only two cheers
• The ETFs Show: tech stocks in the Biden era
• This ETF lets you track tech chip sector – but it’s very boom and bust

Another aspect of the trust I found appealing was its strategy of engaging with management of smaller companies to improve governance. Small caps in emerging and frontier market are not known for strong governance and Mobius et al believe that there is upside to gained in encouraging management teams in this part of the world to improve – and I’m inclined to agree. If governance becomes stronger, the company should be worth more. In theory, this added value will prove beneficial for the investment trust’s own performance. You can’t do that with an ETF.

I also own Baillie Gifford US Growth investment trust (LSE: USA). This trust provides exposure to US tech, which has obviously been rewarding over the past couple years that I’ve held it. Of course, I could have tried to gain similar exposure with an ETF tracking the Nasdaq or some other US tech index. But there was a key feature of this trust that caught my attention when it launched: it can invest up to half its portfolio in unlisted companies.

As has been widely documented, companies are staying private for longer. In a world awash with venture capital, companies don’t need to rely on stock markets to raise money for growth. As a result, new companies see much of their growth when still privately held, going public when they are more mature. So, if you want exposure to companies in their earlier growth stages, an actively managed trust looks like a good option. ETFs can’t track companies not yet listed on the stock market.  

Of course, all this could just be rationalisation. Perhaps I’m coming up with these reasons to convince myself why I’m not just buying the global market and letting my returns slowly but steadily grow over time, which most evidence suggests is the best option. 

Buying the entire stock market might be the optimal strategy, but it is psychologically unsatisfying. By having a small allocation to other types of assets, such as funds or investment trusts, you can at least convince yourself that through your own intellect, skill, or hard work, you have helped boost your portfolio’s performance. I’d be lying if I said I wasn’t a bit smug about the performance of the trusts I mentioned above. You don’t get that by tracking the global index.

Of course, maybe I have just been lucky. I can imagine myself being convinced by the story behind Woodford Patient Capital in 2015, had I been investing back then. Not that I think any of my active funds will go the same way as Neil Woodford’s, of course. But they could still underperform, as the data suggests they will eventually. In 20 years’ time, I may be kicking myself for not simply having all my portfolio in a global index, however psychologically unsatisfying it currently seems.

Tom Bailey invests in Miton UK Microcap (LSE:MINI), Mobius Investment Trust (LSE: MMIT), Baillie Gifford US Growth investment trust (LSE: USA), alongside ETFs.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.