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Active and passive investing: A blended approach

27 August 2020

5 minute read

Many investors question whether active or passive investing delivers better returns. Here, we explain the difference between the two approaches and whether a blended approach may offer the best outcome for investors.

Who's it for? All investors

The value of investments can fall as well as rise. You may get back less than you invest.

What you’ll learn:

  • The difference between active and passive investing.
  • The pros and cons of each strategy.
  • The advantages of taking a blended approach.

Many investors question whether active or passive investing delivers better returns. However, there does not appear to be a simple straightforward answer to this question. What we can say is that whichever approach you choose to adopt can have a significant impact on the value of your investments. But what is the difference between the two strategies, and why does it matter?

Here, we explore the pros and cons of active and passive investing, and consider whether a blend of the two strategies may offer the best outcome for investors although this will depend on an investor’s particular circumstances.

Active or passive?

If you invest in a fund, your money is usually spread across a wide range of underlying investments with the aim of diversifying your portfolio be it in shares, bonds, property or commodities. However, whatever approach you choose to take, it’s important to remember that the value of investments can fall as well as rise, and there’s a chance you could get back less than you put in.

Active funds typically have one goal, which is to outperform a benchmark – usually a market index, such as the FTSE 100. Active funds aim to outperform their benchmark by relying on a fund manager making individual investment choices. Fund managers use their expertise and large amounts of research to decide which investments the fund will hold. They adjust the fund’s holdings on an ongoing basis, in response to performance and changes in market conditions. Fund managers are paid to manage the fund, even if the fund does not succeed in performing better than its benchmark. All these extra resources that active management requires are reflected in the charges that they make compared to passive managers. Active management costs more and might not achieve returns that exceed the difference between active and passive costs. 

A passive fund typically aims to match the performance of its benchmark. The fund is designed to follow the performance of its benchmark, rising and falling in line with the market. 

So, is one strategy better in all cases? 

Active fund managers can spot opportunities for returns and seek ways to minimise the impact of a downturn. Active fund managers won’t always get it right – so the fund could potentially underperform against its benchmark and the wider market. Passive funds don’t have the same opportunity to outperform and will not try to beat the benchmark. In a market sell-off, passive funds will simply follow the market lower. Of course, in a rising market the opposite is also true.

Active funds aim to outperform their benchmark or the relevant market although there is no guarantee that they will succeed. Passive funds will very closely follow the performance of their benchmark without the same risk of underperforming due to fund manager investment choices that don’t pay off. 

In terms of cost, active funds charge higher fees than passive funds. This is because of the additional resources that active managers require in order to try and beat the market return. Therefore, it is important for investors to evaluate whether the additional cost is worth it. In other words, is the extra cost offset by the additional return earned? There will be some instances where the return may not cover the additional charges. When investing in an active fund, it is never possible to know whether the additional cost will be covered by the return. This is not the case with passive funds which only ever aim to track the market return.

A blended approach

But you don’t have to choose between active or passive funds. In fact, you might want to consider investing in both types of funds as a path towards diversifying your portfolio. Why? Because active strategies have tended to perform better in periods of market turbulence because the fund manager can make decisions independent of the market direction. However, just because active managers may have performed better in the past does not necessarily mean they will continue to do so in the future. 

Passive strategies have the potential to offer better returns when shares are generally moving together in the same direction because there is less opportunity for a fund manager to outperform through stock selection. Blending the two approaches can therefore offer investors the benefit of diversification.

Passive strategies can achieve market exposure cheaply and efficiently in certain markets. Active strategies can extend the reach of that portfolio and help manage risk and potentially deliver additional performance. 

Where you decide to invest can also determine whether it is better to buy an active or passive fund. For example, a long-term investment in large companies can often be efficiently met with passive funds.

However, investments in the mid and small cap (mid-size and smaller sized companies) segments of the market for example may be better served with actively managed funds. This is because shares in this space can still offer attractive opportunities as opposed to the large cap segment where similar opportunities are often limited.

In addition, liquidity constraints – or the ease by which you can buy and sell the shares – in the mid and small cap segments may also make it difficult to execute a passive strategy.

Conclusion

Investors should not look at this as a choice between active or passive but rather consider how best to harness the advantages that both strategies offer. Passive funds can play the anchor for the long-term, lower risk segment of the portfolio while active funds can help take advantage of market conditions and in segments of the market where they can generate better risk-adjusted returns.

To best navigate the current market uncertainty, we would advocate taking a long-term diversified approach to investing. The Barclays Ready-made Investments are just one example of a range of diversified funds which allow you to select the level of risk you are most comfortable with. These multi-asset funds invest across a range of asset classes and regions, offering a globally diversified one-stop solution for investors. Ready-made Investments are not the only funds that we offer and they won’t be appropriate for everyone. 

Smart Investor offers a wide range of funds, and our Barclays Funds List may help you to narrow down the wide range available to invest in. These funds are selected by Barclays investment specialists and, based on our research, they’re the funds that have built solid reputations and established sound investment processes.

We don’t offer personal investment advice so if you’re unsure you should seek that independently.

Funds are designed for the long term so you should only consider them if you can stay invested for at least five years.

All of these investments can fall in value as well rise; you may get back less than you invest.

These are our current opinions but the future, as ever, is uncertain and outcomes may differ.

Find out more about our Ready-made Investments.

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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. Smart Investor doesn’t offer personal financial advice. If you’re not sure about investing, seek independent advice.

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