Active versus passive funds: a beginner’s guide

by Tom Bailey from interactive investor |

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We explain the pros and cons of active funds and passive funds.

One of the biggest divides in investment is the subject of active funds versus passive funds.

Some investors believe it is best to invest in an actively managed fund, in which a manager and team of researchers pick the shares they believe will perform best. Others believe the best option is to buy a passively managed fund, which mirrors the ups and downs of a specific market index.

Rather than picking one over the other, most investors opt for a mix of the two approaches in their portfolios. But having a good understanding of the difference between the two approaches is crucial. Below, we explain the basics.

Active funds

The basics

As mentioned above, an active fund has a fund manager and a team of researchers who select the shares that they believe will perform better than other shares. The idea is that the skill of the fund manager, combined with their research capabilities, should allow them to identify the shares that are likely to excel.

To measure their performance, funds often use a stock-market index as a benchmark. This benchmark is chosen to be comparable to the portfolio of stocks that the fund manager puts together. For example, a fund manager who buys UK shares may use the FTSE All-Share index as their benchmark.

The return of a fund over a given period of time is then measured against the benchmark. A fund manager who provides returns higher than the benchmark is said to be “outperforming”, while those providing returns lower than the benchmark are said to be underperforming.

For example, if Fund A provides a return of 15% for the year and the FTSE All-Share provides a return of 10%, the fund is beating its benchmark and providing outperformance of 5%. On the other hand, if Fund B provides a return of just 8%, it is underperforming its benchmark by 2%.

The ability to provide a better return than the market is the key attraction of actively managed funds, but there are no guarantees.

Characteristics

Active funds will be more expensive

The fund manager’s salary and his or her resources cost money. As a result, active funds tend to be more expensive than passive funds.

A typical active fund will charge somewhere between 0.75% and 1% a year (known as the ongoing charges figure), which is higher than the majority of passive funds.

Active funds have a range of strategies

Fund managers have an investment style or strategy. Investors should be aware of how the fund manager invests, as it can mean a very different mix of shares and potential performance. For example, managers with a “growth” style select shares that tend to prioritise reinvesting profits back into the business, while an “income” fund manager will focus on firms that return cash to shareholders in the form of dividend payments.

Active funds offer the chance of outperformance…but there no guarantees

As noted above, the performance of active funds is measured against a benchmark index. But there no guarantees  that an active fund will outperform the benchmark.

Some funds fail to outperform due to having a portfolio that too closely resembles the index. Such funds are said to be “hugging the index” or “closet trackers”. A quick way to check is to look at the fund’s top 10 holdings and compare them with the top 10 holdings in the benchmark index. A large overlap should set off warning bells.

Most funds, however, take a more active approach, in an attempt to add value by outperforming the index.

If the fund manager is right in their choices, performance can be great. However, if the manager is wrong, investors may have been better off buying the market through a passive fund, which has cheaper fees. Costs add up over time.   

Passive funds

The basics

One of the core arguments for passive funds is that fund managers cannot consistently identify the stocks that are going to do well. Rather than trying to buy the best shares, passive funds aim to replicate the performance of an index.

A simple way to understand the difference between active and passive is to think of active managers as trying to uncover needles (good shares) in a haystack (the market). Passive funds, meanwhile, buy the whole haystack, knowing that the needles are in there somewhere.

Passive funds come in two forms: index funds and exchange traded funds (ETFs). The core difference is that unlike index funds, ETFs can be traded throughout the day on the stock market, much like individual stocks. For long-term investors, the difference is not important.

While the purpose of most ETFs and index funds is to track a broad, well-known index such as the FTSE 100 or S&P 500, in recent years a new breed of passive fund has emerged, which blends elements of passive and active fund management.  

For example, some ETFs now screen stocks based on certain characteristics or “factors”. For instance, some ETFs track a basket of stocks deemed “value” – that is, those stocks trading at cheap valuations. Alternatively, you can buy an ETF that screens for growth or dividend shares. The idea is that screening for these factors will lead to better performance than the market.

Other ETFs follow an index composed of shares related to certain themes. For example, an ETF may track the theme of electric cars. Usually this entails tracing some pre-made index of electric car manufacturers (and sometimes other ancillary companies deemed part of the same theme, such as lithium miners). These are often called thematic funds.

The key point to remember in terms of how these products differ from actively managed funds is that they invest according to a pre-determined set of rules. Once the ETF has been set up and its rules decided, it should be investing on autopilot, meaning it tracks the ups and downs of the index, like other passive funds. Bear in mind that these funds often cost more than an ETF tracking a more mainstream index.

Characteristics

Passive is cheaper

For the most part, passive funds are cheaper than active funds. Often, there are also fewer trading costs. The annual costs for an exchange traded fund tracking the FTSE 100 index can be as low as under 0.1%, which works out at less than £1 on a £1,000 investment.  

Passive funds are readily tradable

Passive funds are often large and liquid, so it is easy for investors to move in and out quickly. This is particularly the case with ETFs, which as mentioned above can be traded throughout the day.

Passive will not protect capital in a market downturn

As there is no manager overseeing the portfolio, passive funds will fall in line with the market. In theory, active funds can take measures to protect capital when markets fall, such as moving into cash, or buying more defensive shares.

Passive fund performance often means buying yesterday’s winners

If a passive fund is based on a market capitalisation-weighted benchmark, such as the FTSE 100 or S&P 500, it will include more of the larger stocks in the index that have already seen a rapid appreciation in price.

In contrast, active fund managers have the flexibility to search for tomorrow’s winners – for instance, small companies that could one day become big businesses.

However, as mentioned above, there are no guarantees that an active fund manager will outperform the benchmark.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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.

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