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Differences between active and passive investing

07 December 2017

Funds may be divided into two main types - active and passive. Both aim to make money from their underlying assets, but how do they differ?

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

What you’ll learn:

  • How active and passive funds work.
  • Why actively managed funds typically cost more than passive funds.
  • How to decide which approach is right for you.

Investors can choose from two main strategies to generate returns in their portfolio: active and passive management.

In general, active management aims to outperform the market compared to a specific benchmark, while passive management mirrors the investment holdings of an index and its performance. However, with around 4,000 actively-managed funds and 150 passive funds listed by the Investment Association, it can be tricky to choose which is right for you.1 You might decide to consider investing in both types of fund as a way of diversifying your portfolio.

Here, we explain the main differences between active and passive investments. If you’re unsure what to invest in, you may want to seek professional financial advice.

1. How they are managed

When you invest in an active fund, your money is pooled with that of other investors across a range of investments – and, there’s a fund manager in charge who actively chooses what the fund invests in. The manager aims to make investments which deliver returns that beat the fund’s particular benchmark, with a team of researchers and analysts to support them in achieving this aim.

By contrast, passive or ‘tracker’ funds aim to deliver a return that’s in line with a benchmark, mirroring the movements of the particular index or asset they’re tracking. For example, among the most popular type of passive funds are those that track the FTSE 100 index of Britain’s biggest companies, or the FTSE 250, tracking medium-sized firms. Passive funds may also be stock market listed exchange traded funds (ETFs), as well as Unit Trusts and open ended investment companies (OEICs).

2. Underlying investments

Passive funds will usually invest in the underlying assets of the index they’re tracking, or a representative sample of these. A fund tracking the FTSE 250, for example, will typically buy shares in all the companies listed on the index in the same proportion as their market value, and in this way the fund’s performance moves in line with the Index.

Some sectors, such as commercial property, for example simply cannot be mirrored by a simple tracker fund, as they buy commercial properties and pay returns based on rental income and capital value increases. If an investor wants to put money into an area of investment that’s considered specialist, they will often have to choose an active fund.

Managers of active funds can pick from a wide range of investments to hold within a fund, making careful decisions over where to invest for the best returns. For example, an active fund investing in emerging markets could potentially invest in a vast universe of stocks that fall within this geographical region.

3. The costs involved

Investors will typically pay a higher annual fee for the expertise of an active fund manager, often amounting to between 0.6% and 1.5%. However, the cost will depend on the particular fund they choose. Some specialist funds may be more expensive than a general equity income fund, for example. Whether it is worth paying these higher costs will depend on whether the fund manager outperforms its market benchmark; the higher charges will tend to reduce the net return more than the passive manager’s lower charges.

One of the major reasons people choose passive funds is their lower charges, with access to some of the world’s biggest stock markets. Charges can sometimes be as low as around 0.1%, although the amount charged will depend on the performance of the index being tracked.

As passive funds are operated automatically, rather than relying on the expertise of a fund manager, their running costs are low. Over time the impact of charges can have a significant effect on investor returns, so they are a key factor for some investors when deciding which fund to choose.

Find out more about fund charges

4. Their goals

An active fund manager will aim to outperform a particular benchmark, whereas a passive fund typically aims to match the performance of its benchmark. It’s impossible to predict exactly the way that a particular fund may perform, whether it’s passive or active. The performance of the market depends on a wide range of factors, including political and economic conditions, inflation, deflation, and issues that may particularly impact specific companies and sectors. Whilst an active fund’s objective is to outperform a benchmark it may not achieve that aim, performing less well and may experience greater losses or smaller gains.

While the aims of passive and active funds are different, both may produce returns or losses for investors. Active funds may fail to beat their particular market, with the underlying investments not performing as hoped. In this case, passive funds may deliver higher returns, but remember that if the index receives a shock and falls, so will your investment.

Some people claim that passive investments cannot protect investors from periods of volatility, unlike active investment where a manager can keep a close eye on wider economic conditions and tailor a portfolio to weather a potential storm. However, it’s also been argued that some active fund managers fail to consistently beat the market over the longer term.

Whichever approach you choose, remember that past performance isn’t a reliable indicator of future performance, and the fortunes of any passive or active fund may change direction.

What might be right for you?

The right investment choice for you will depend on a number of factors, including your investment goals and risk tolerance, and whether you are confident the active manager can beat a benchmark and make the higher charges worthwhile. Given that developed markets such as the US and the UK are so widely researched, it can be particularly difficult for managers to spot opportunities that others have missed, so you might consider that opting for a passive fund may make more sense in this case.

In comparison, regions that are considered greater risk and are subject to less analysis, such as emerging markets, may benefit from the expertise of a fund manager. Markets such as these are typically less efficient, and the specialist knowledge and experience of a fund manager could potentially produce greater returns by tracking down the best assets, although there are no guarantees. Other examples of more specialised areas of investment that may possibly benefit from an active approach include healthcare, technology and smaller companies.

However, whichever option you choose, or whether you decide to invest in both active and passive funds, you have to accept that your investments can still fall in value as well as rise and you might get back less than you invest. If you’re unsure where to invest, consider taking professional financial advice.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.

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