Active vs passive investing guide
What are the differences between active and passive funds? How do those differences affect performance, and which option is likely to suit you better?
What is active investing?
Active investment is a form of investment strategy that involves the fund manager making judgments and using investors’ money to actively buy and sell assets in the hope of making profits and outperforming a benchmark or index.
What is passive investing?
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.
Passive investment involves investors’ money being used to buy a “basket” of investments in line with a particular index; the weighting of each holding is automatically adjusted to follow the index over time. This might be an equity index such as the FTSE All-Share or the S&P 500, or a commodity or fixed income alternative.
These days there are also numerous more sophisticated passive strategies, for instance following weighted indices designed to focus on themes such as income or value investments.
What's the difference between active and passive investment?
Actively managed funds are run by human managers who pick and choose their investments in an attempt to outperform the fund’s benchmark – often a stock market index chosen because it is comparable with the fund’s portfolio of holdings.
Passive funds are run by algorithms that simply track the fortunes of that index, for better or worse, so they are not reliant on the abilities of a stock-picking manager to make the right calls. That also makes them cheaper to run.
The UK market has historically been dominated by active managers. However, the strong trend in recent years has been towards passives. Index trackers accounted for over a third of total UK assets in 2020, according to the Investment Association’s latest report - up from a fifth in 2010.
By definition, index trackers will never beat the market they follow. But the trouble is that neither will the majority of actively managed funds.
According to the 2022 S&P Index Versus Active (SPIVA) report, 55% of UK equity funds, 75% of European funds and 85% of US large-cap equity funds underperformed their benchmarks in 2021.
Active vs passive investment comparison
Management fees are more expensive because of the greater human input.
There are no expensive managers to pay for, so fees and expenses are typically lower than for actively managed funds.
Key person risk
“Star” managers represent “key person risk” - if they leave the firm, there is no guarantee that whoever takes over will do an equally good job.
There is no key person risk, because there’s no key person.
Capacity for human error
Managers can make the wrong call, and the fund will underperform as a consequence.
Trackers follow their benchmark indices pretty closely, so there are unlikely to be any big surprises, for better or worse.
Flexibility to deal with falls in the market
Active managers have the flexibility to protect their portfolio against potential losses.
There is nowhere to hide if the market falls. Your investment is bound to follow it and the only way out is to sell.
Capability to deal with the nuances of the market
It’s easier for active managers to assess companies on more complex considerations such as the quality of a company’s management team or the strength of its hold on its market.
Most indices operate on market capitalisation, which means your holding can be skewed towards the biggest companies and most popular sectors, which can be a vunerable position.
When could active investing work well for you?
- If you’re going to invest in actively managed funds, you need to be prepared to do some research (or pay a financial adviser to do it for you). There are excellent managers with strong long-term records to be found.
- Smaller companies tend to be much less well researched than large ones, so good active managers have more chance of finding interesting opportunities.
- Similarly, newer and less familiar regions such as emerging markets can provide rich pickings for specialist managers with in-depth expertise and flexibility.
- If you want to know your money is invested in companies with strong ESG practices, active managers are likely to be a better bet. Not only can they research each company’s principles and practices but they may actively engage with management to get them to make positive changes.
- Investors looking primarily to protect the value of their capital (rather than to grow it or generate an income) can make use of multi-asset funds and investment trusts. These are run by very experienced managers and managed so as to do just that. Index tracking funds, in contrast, are by definition unable to protect against market falls.
When could passive investing work well for you?
- Index tracking funds are a good starting point for beginners looking for a cheap and easy way into stock market investment.
- If you don’t have time or inclination to research and monitor active fund managers, passive funds providing broad exposure to different regions may be a better option. You will at least more or less keep up with the market.
- If you’re interested in exposure to a broad market where there is relatively little differentiation, passive investing offers an easy and low-cost way in.
- It’s particularly difficult for active managers to beat the benchmark for US large-cap funds, because the huge companies they invest in are so well-researched that there are few opportunities for them to unearth hidden gems or bargains.
Combining active and passive investments
There is no straightforward answer as to which approach is “best”. Many professional portfolio managers believe there is a place for both in a well balanced portfolio.
For instance, you could hold a core of broad market exposure using passive funds, and then “bolt on” actively managed funds focusing on the likes of smaller companies, emerging markets, sectors such as healthcare, or specialist themes such as water.
Or you could use active funds you know and like, supplemented by index trackers following markets or assets that you’re less familiar with.
Did you know
This tax charge applies on all investments that produce dividends, even where they are reinvested rather than paid to you.
Learn more about investing
Learn how to make the most out of your investments with our useful guides.
Please remember, investment value can go up or down and you could get back less than you invest. The value of international investments may be affected by currency fluctuations which might reduce their value in sterling.