Four differences between active and passive investing

What you’ll learn:

• How active and passive funds work.
• Why passive funds costs less than active funds.
• How to decide which approach is right for you.

When you invest in funds, there are two main approaches to choose from – active and passive.

In general, actively-managed funds aim to outperform the market as measured by a specific benchmark, such as the FTSE 100 index of the UK’s biggest companies. Passive funds, however, such as Exchange-Traded Funds (ETFs) and tracker funds, simply mirror the investment holdings of an index and its performance.

In August this year, the investment industry reached a major milestone, as the amount of US investors’ money in passive funds overtook the amount invested in active funds for the very first time. According to estimates from Morningstar, investors added $88.9 billion to passive US funds in the year to August, whilst pulling $124.1 billion from active funds. Assets in passive US funds stood at $4.271 trillion in August, compared to $4.246 trillion in active funds.¹

The UK has also seen a shift towards passive fund management, with latest Investment Association figures showing that £4.6bn was poured into tracker funds between June and September this year. Tracker funds under management stood at £220 billion as of the end of September, and their overall share of industry funds under management was 17%. A decade ago, there was £31 billion under management in tracker funds, equivalent to a 6% share of industry funds.²

Here, we explain the main differences between active and passive investments to help you decide if either might be right for you. Remember though that it doesn’t have to be a case of either one or the other – you might decide to invest in both types of fund as a way of diversifying your portfolio or you might find that investing is not for you.

Please remember we don’t offer advice, so if you’re unsure which funds to invest in, you may want to seek professional financial advice. Both of these types of investment can fall in value as well as rise and you may get back less than you invest.

1. How they’re managed

When you invest in either an active or passive fund, your money is pooled with that of other investors across a range of investments. With an active fund there is a fund manager in charge who actively chooses what the fund invests in, making careful decisions about where to invest for the best returns, with a team of researchers and analysts to support them. The manager aims to make investments which deliver returns that beat the fund’s particular benchmark.

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. The costs involved

Investors will typically pay a higher annual fee for the expertise of an active fund manager, usually amounting to between 0.6% and 1.5%. However, the cost will depend on the particular fund they choose and what it invests in. Charges for passive funds are generally much lower than this.

For example, the typical cost of active UK equity fund on Smart Investor is around 0.85%, yet a tracker fund investing in the FTSE 100 would usually cost about 0.1%.

Whether it is worth paying higher costs for an active fund 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.

Running costs are low for passive funds as they are operated automatically, rather than relying on the expertise of a fund manager. 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.

Mike Haslam, Head of Funds Distribution at Barclays, said: “It’s important to look at funds in terms of ‘value for money’. Like anything in life, from food and clothes to cars and houses, we typically pay for things if we feel we are getting value for money. And it’s the same in investments, where actively managed funds cost more than passive funds, but some of those are certainly worth paying for and others certainly aren’t.”

3. 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 important to appreciate that the performance of a passive fund and an active fund invested in the same market (such as UK shares) will always be at the mercy of how that market itself performs. If UK shares fall in value, it is likely that both passive and active funds will fall in value together. 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.

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 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.

4. Transparency

It’s easy to know what a passive fund invests in because it tracks an index, so investors know exactly where their money is going.

However, active funds are usually less transparent, with active managers often reluctant to disclose their holdings on the basis that their investment ideas could then be used by competitors.

The Investment Association, the trade body which represents UK investment managers and companies, recommends that funds should disclose their complete list of holdings at least twice a year in their annual and half-yearly reports, but there is no rule requiring managers to publish this information online.³

Active funds do however usually disclose their top 10 holdings each month, typically on the fund factsheet. If you’re a Smart Investor customer, you can view the top 10 holdings of most funds on our fund fact pages once you’ve logged in.

Which 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 an active fund manager. 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.

Mike Haslam said: “Passive and active funds can both have a place in diversified investment portfolios. In fact, passive funds now offer a cheap and transparent way for investors to gain exposure to virtually any investment market in the world, in a way that just was not possible 10 years ago.

“But the rise in popularity of passive investments highlights how difficult it can sometimes be to find good actively managed funds. Such funds do exist, but it’s clear that it can sometimes take a lot of work and research to find them. Investors can typically start by looking at independent fund ratings or maybe at ‘best buy’ lists, but ultimately it makes sense to seek professional financial advice.”

Whichever option you choose, or whether you decide to invest in both active and passive funds, you must accept that your investments can still fall in value as well as rise and you might get back less than you invest.

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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.