Investing in its most simple sense is the process of laying out money today with the hopes of receiving more money back in the future. And there are really two ways of accomplishing this aim, active investing and passive investing.
Active investing, as its name suggests, involves being active with your investments. That means picking stocks, bonds and other assets to go in your portfolio based on your analysis of the underlying investment. Active funds use the same investment approach.
Passive investing is all about letting the market do the hard work for you. Rather than trying to pick stocks and outperform the market, passive investing involves buying the whole market through a passive tracker or index fund.
There is a bit of a crossover here, as some investors may prefer to buy a selection of passive funds to build exposure to different markets. This is a form of active investing, but for the sake of simplicity, in this article, we’re going to look at the difference between active investing funds and passive investing funds, and discuss whether one strategy is better than the other.
What is an active fund?
As the name suggests, active investing requires active decision-making.
An active fund will employ a portfolio manager to hand-pick stocks (or other assets) to buy and sell when they think it’s the right time based on how they’re performing.
A smaller basket of stocks might seem more protected from wider market turmoil, but timing and beating the market is hard and active managers aren’t guaranteed to succeed.
According to data from Morningstar, out of 3,000 active funds only 30% outperformed their average passive peer in the 12 months to June 2022. Over the ten-year period to June 2022, only one in four active funds topped the average of their passive peers.
This is a problem given the hefty costs active funds charge. If you’re paying an active manager, you’d expect them to deliver. But, as the data shows, this isn’t always the case.
Actively managed funds charge a fee of between 0.75% and 1.25%, according to Which?, which can eat into your returns. There’s an even bigger downside if the returns don’t beat the market.
That said, some active managers are able to deliver consistent returns and have quite a good record.
Morningstar is useful for looking at a fund’s performance, and it’s a good idea to regularly check if the active fund you’ve invested in is outperforming the market as that will help you determine whether you want to keep your money there or look into passive funds instead.
What is passive investing?
Passive funds, such as index funds or tracker funds, aim to deliver the same returns as the market. An index fund will copy the composition of an index, such as the FTSE 100, and if you buy into it you’re effectively investing in all the companies that make up the index.
This allows you access to a diverse range of companies. The main downside is that there is no chance of outperforming.
When you invest in a passive fund, you should look for a low tracking error – that’s the difference between the fund’s performance and its underlying index’s performance.
The stocks in a passive fund shouldn’t change much – only when the constituents of the underlying index change. So if returns significantly differ from the index, it means the fund might not follow a passive strategy after all, or that you’re paying extra fees.
Passively managed funds also carry far lower fees than actively managed funds do, which adds to their appeal. According to Which? they range from as little as 0.1% to 0.85%.
Which are better: active funds or passive funds?
Their low fees coupled with the fact active managers rarely manage to outperform the market for long make a pretty good case for passive funds.
However, if you want access to a specific sector instead of the very wide range of companies that make up an index, you might want to look into active funds with a good record.
• With additional contributions from Rupert Hargreaves.