Active and passive funds: which investment option is right for me?
If you're considering your investment options, an actively or passively managed fund could deliver results that are suited to your individual financial objectives.
Most of us are aware of the importance of building a nest egg to ensure the fulfilling and comfortable retirement we all deserve. It’s also just as crucial to start early, allowing us to build a savings pot that can handle the bigger expenses life throws at us.
The deposit on a first home, an additional investment property, or to give a child or someone else close to us a leg-up onto the property ladder, all require a significant cash lump sum.
Weddings, further education, starting a new business venture or the holiday of a lifetime are also all expenses that can crop up over the years and require funding that doesn’t fall under the usual budgeting considerations.
Using smart, risk profile-appropriate investments to grow cash savings over the years has always been the best approach to achieving financial security.
In the present environment of historically low-interest rates on cash savings and quickening inflations, it’s even more crucial to protect the real value of wealth through the right investment products.
In years gone by, interest rates that were comfortably higher than inflation meant cash savings would still slowly grow over the years if held in a savings account. Now the real value of cash is slowly eroded month by month through inflation of 2.5% to 3%, against interest rates of around 0.25%.
Investment in products that offer a realistic chance of beating inflation is the only option open to UK savers who don’t want to see the purchasing power of their savings being slowly chipped away at. The array of investment options available to savers, from company shares to bonds, real estate or funds, often proves disconcerting to those who don’t have a financial background or experience in investing.
Funds are the most common investment choice for SIPP and ISA investors who don’t feel comfortable or have the time available to do their own analysis of individual company shares to invest in.
However, there is also a huge choice of different funds available to choose from and savers can often find themselves wondering where to start when it comes to making a decision.
In this post, we’ll tackle one of the first questions investors considering funds often have. What is the difference between active and passive funds and is one or the other the better choice for me to achieve my investment goals?
For those who are just starting out, let's begin with the following...
What is a fund and why invest in one?
In a nutshell, a fund is an investment vehicle that pools together the money of multiple individuals and invests their capital into a diversified range of securities or physical assets. These can be individual company stocks, indices, bonds, commodities or property and is often a combination of two or more of these asset classes.
Depending upon the investment targets of a particular fund, the underlining investments will aim to either deliver capital growth or income to investors, or a combination of the two. Funds are categorised into groups on the basis of their investment targets and the kind of securities they invest in.
Investors will usually choose to invest in a fund because they don’t possess the time or expertise to devise a well-diversified and risk-appropriate portfolio themselves.
What’s the difference between active and passive funds?
Whilst funds are categorised based on investment aims and the nature of the securities invested in, another differentiator between funds is whether they are actively or passively managed.
Actively managed funds
Active funds have a fund manager, supported by a research team. The fund manager is an experienced professional investor who will pick the securities a fund initially invests in. They will then adjust that original selection on an ongoing basis to keep the fund on track to achieve its investment aims, as general market conditions and the performance of individual securities change.
What are the benefits and disadvantages of an active fund?
The main benefit of active funds is that fund managers re-balancing investments defensively should help limit losses during market downturns or crashes. Also, while famously most active funds don’t consistently beat the market, when returns are averaged out over several years there are some fund managers who do provide investors with market-beating returns.
The downside to active funds is that higher management fees eat into returns. They typically charge between 1% and 2% per annum so the fund manager has to beat the market by a good margin to do better than a passive fund.
The facts are that in Europe, 87% of all active equity funds are underperforming the benchmark index over 10 years (ft.com, April 1, 2017). When higher management fees are also taken into account, there isn’t a high percentage of active funds on the market that can really be said to deliver investors value for money.
Passively managed funds
Passive funds do not have an active manager adjusting the securities invested in. The fund is invested in an index (like the FTSE 100) or a commodity (like gold) and investors then achieve the same returns as the underlying market.
A passive fund will not see its investments adjusted and in the case of a market dip for the underlying market, will rely on the cyclical nature of markets subsequently leading to a recovery of any losses.
What are the benefits and disadvantages of a passive fund?
The main advantage of passive funds is their cost – because they don’t have the hefty salary of a fund manager and their research team, annual management charges can be as low as 0.1%. Simplicity is another strength, with investors knowing exactly what they're buying into.
Another argument supporting passive investing is that over the longer term, the kind of major markets that the indices’ passive funds invest in have returned reasonably strong returns.
While there is no guarantee it will always be the case in the future, the major equity markets, such as the UK and U.S., have always recovered from downturns and crashes and gone on to fresh heights. Between 1950 and 2009, adjusted for inflation and on the basis of compounding dividends, the average return of the S&P has been an annual 7% return on investment.
The FTSE-all share index, which tracks the entire London Stock Market, has, on the same basis, returned an average of approximately 10% per annum over the past 20 years.
The downside to passive funds is that they will typically suffer heavier losses than active funds when markets take a downturn or crash. While losses would be expected to be recovered over time as markets bounce back, which they historically always have, if the investor needs to cash in their investment before that happens, losses would likely be more pronounced.
A further disadvantage to passive funds is that while indices contain a reasonable to a very large number of different companies, they can also be quite concentrated in a particular sector and so more exposed to it than is ideal for a balanced portfolio.
For example, the FTSE 100 has a lot of big banks and big oil and gas companies that carry significant weightings within the index. Hard downturns for those industries, therefore, hit it significantly, despite the fact it’s made up of companies from a wide variety of sectors.
Should I invest in an active or passive fund?
The question posed doesn’t have a single or definitively correct answer. A well-diversified portfolio will, in most cases, contain a mix of both active and passive funds of different characters, as well as individual equities and other asset classes, such as bonds.
Smaller investors with limited funds will often be better investing in a few passive funds because of the lower expense ratio. However, there are also very good active funds that consistently deliver strong results and they shouldn't be entirely written off as a fund category. The trick is being able to know which these are, though there are online resources that analyse the long-term performance of active funds and rank the best.
If you feel that you would benefit from professional guidance in your portfolio choices, we’d be happy to provide an initial consultation to discuss your needs. Please do not hesitate to contact us by completing an online enquiry form, or simply give us a call.
The value of investments and the income derived from them may go down as well as up. This article is for guidance and should not be deemed as a personal recommendation. You should seek professional advice before proceeding with any course of action.