What’s the difference between passive and managed funds?

Sam Meadows 20th Jan 2022 No Comments

Reading Time: 8 minutes

We hear all about all sorts of funds that we could be putting our money into. It can seem confusing, particularly when you have to ask yourself what the difference is between passive and managed funds.

Hunting for little-known companies that look set to be the next big thing (and make you buckets of cash in returns!) is part of the fun of investing, but most amateurs will be perfectly happy leaving their stock picking to the professionals.

Why take on the hassle and the stress that comes with looking after your nest egg, when there are a host of professionals who dedicate their working hours to getting you returns? For a modest fee of course…

However, even there it isn’t that simple. There are hundreds of investment companies employing thousands of people in the UK to run investment funds and choosing the right people to entrust your money to can be a challenge. After all, you want it to be in the best hands possible!

But are those hands human or robotic? If you aren’t sure what I mean, then welcome to the debate that has raged in investment communities for decades: active v passive.

This guide will introduce you to what those terms mean and (hopefully) give you an idea of which approach will be best for you, together with an answer to the question – what’s the difference between active and passive funds?

What is an investment fund
Active VS passive
Rise of passive funds
Why should I go passive?
Is there any point in going active?
How do I invest in funds?
So, which way to go?

What is an investment fund?

Before we get started, I used the term investment fund earlier and you may be asking: what is one of those?

Crudely speaking, an investment fund is a basket of companies (usually around 30 or 40) that has been curated to provide an investment return. Rather than you (the amateur investor) individually choosing which company shares to buy, a manager or a machine (more on that later) has done the choosing for you.

You buy a share of the investment fund, and sit back and let the returns roll in – well that’s the plan anyway…

For beginners and seasoned investors alike funds are useful as they automatically diversify a portfolio. The first rule of investing is never to put all of your eggs in one basket. If all of your pension was invested in BT and it went bust then you would have lost your entire pension. If just 5% of your pension was invested in the company then the impact on your overall savings would be much less.

Well funds give you diversity built in as they are made up of a range of different companies.

You will pay a small fee to own a fund – which pays for the fund provider’s overheads like staffing and research costs.

Some well-known names in the world of fund providers are Vanguard, Fidelity, BlackRock and Legal & General, but there are many, many more.

There are different types of funds with slightly different entry and exit requirements, but this guide is on the different approach taken by the firms to choosing their stocks.

Which brings us to the main debate: active or passive?

Active vs passive

Active or passive refers to the way that a fund is managed and stocks are picked.

An “actively” managed fund is overseen by a fund manager who picks which stocks to buy and sell and, in theory, is constantly scouring the market for opportunities or the warning signs of a downturn.They are usually supported by a team of analysts, but some are more independent. Actively managed funds will usually trade fairly often by investment standards, buying and selling stocks in reaction to the market.
Passive funds, on the other hand, are run by computers and simply aim to track a specific part of the market. A common example is the FTSE 100 (the index of the biggest UK companies. Instead of a person choosing which stocks to invest in, passive funds, also known as “trackers”, recreate the performance of the set index or market. Using the example above, if the FTSE 100 performs well then the fund would grow in value, but if it performs poorly then so would the fund. In contrast to actively-managed options, passive funds are closer to the buy-and-hold investment strategy, meaning they make far fewer trades.

Rise of passive funds

Passive funds are a long way from the romantic historical idea of frantic investors trying to find the next undervalued stock.

They trace their origins back to the 1970s when The Vanguard Group launched the first mutual fund looking to replicate the performance of the S&P 500 – a stand in for the US stock market – at a low cost.

The idea was to give everyday people easier access to the stock market. Many more have since followed. Changes to the investment market in the 1990s meant the approach was popularised even further.

Today, passive funds are available tracking everything from the FTSE 100 to emerging markets to corporate bonds.

Vanguard remains one of the best-known names in the market for passive funds.

You can find out more about ‘tracker funds’ in this article.

Why should I go passive?

If you’ve been paying attention you may be asking why on earth you would consider a passive fund. After all, they sound inflexible. If the FTSE 100 hits a downward spiral and you own a fund tracking it, that spells bad news – and losses.

You would be right, and this is one of the major downsides to passive investing. Even if the managers of the fund spot the early warning signs of a downturn threatening their target market, there is usually little they can do in the way of trading out of it.

However, there is one major factor that makes passive funds well worth considering, particularly for casual investors: price.

As detailed above, all funds have a management fee to pay. However, passive funds tend to be far cheaper. The average annual cost of a passive fund is around 1%, according to Business Insider. This is compared to 1.4% for actively managed funds. Over time this can make a significant difference to returns.

Passive funds are also arguably less risky than their active counterparts as the lack of chopping and changing reduces the opportunity for mistakes to be made. While an active manager could make a genius pick that massively boosts returns, they could also make a mistake which dents any potential profits.

With tracker funds you get what you get. It is far less complicated.

There is one more reason to consider passive over active. And it’s a big one.

Active managers don’t usually beat trackers. It’s true. Despite the extra cost, the manpower and the expertise that goes into them, the managers don’t usually beat the robots.

According to a recent report by investment platform AJ Bell, only a third of fund managers beat a passive alternative in 2021. In the US and global sectors, seen as crucial investment markets, the trackers have won for the past decade. In the US markets in 2021 fewer than a fifth of managers beat the index.

Laith Khalaf, an analyst for AJ Bell, said this was likely to be because the US market is so heavily analysed and dominated by tech stocks that it is difficult to “find an edge” – an undiscovered gem of a company in other words.

So is there any point in going active?

Despite the above, the answer is still yes. So, only a third of managers beat the trackers. But, if you can pick one of those to look after your money then you would be in luck.

The ultimate truth is that, as obsessed with your investments as you might be, you simply won’t be able to match the resources that a fund manager has at their disposal. They have access to the best financial information and analysis, a team behind them and, crucially, the time that comes with investing as a full time job.

They also, depending on the size of their fund, have the opportunity to meet with company leadership to make a personal assessment on how professional and viable their prospects are.

This gives them an edge when it comes to stock picking. It means they might be more likely to pick a winner.

The flip-side of this is that their constant efforts to find undervalued or overlooked companies does up the chances of them choosing a dud. A good manager can mitigate this risk by diversifying their portfolio and being sensible with their choices.

But mistakes do happen. Billions of pounds was threatened when former star manager Neil Woodford’s fund ran into trouble a few years ago. His specialism was finding small companies that were set to hit the big-time. Unfortunately things began to turn south.

How do I invest in funds?

Whichever fund types tickle your fancy, the first thing you will need to do is open an account with a stockbroker.

The most common account for amateur investors is a stocks and shares ISA. This allows you to invest in funds or company stocks directly. Plus, as long as you save a maximum of £20,000 a year, your returns will be tax free.

There are several places you can open a stocks and shares Isa, from your high street bank to a a stockbroker.

If you want free choice of funds then the latter is the best option. Some well-known stockbrokers include Hargreaves Lansdown and Interactive Investor. You can also open accounts directly with a fund house like Vanguard. See this article for more information on investment platforms.

Whichever route you choose there will be charges.

The fund provider will charge an annual fee,
as will the broker you choose.
Make sure you read the small print and understand how much you will be paying before opening the account.

Actually opening your account is easy. You will just need a few minutes and some personal information like your national insurance number and bank details.

So, which way to go?

There are advantages to either the passive or active approach.

With a passive fund you can get a cheap option with rock-bottom fees that will follow the market. Over the long term the markets will almost certainly rise. However, you may have to put up with short term dips and crashes. Be aware that these can take years, even decades to come back from.
With an active fund, you could well beat the market thanks to the expertise of your manager. This means you can take advantage of big jumps in the value of individual companies. However, you may also have to weather some bumpy roads if mistakes are made.

So…

If you are choosing an active fund manager, the key thing is finding the right one. Mr Khalaf’s advice is to pick a “seasoned” manager with a proven track record. But, of course, just because someone has performed well in the past, it doesn’t mean they will in the future.
For those choosing a tracker fund the key thing to look for is price. The annual charges on a tracker fund should be low. There are options out there which charge as little as 0.06%, but still many charge far more than this. If you overpay on charges this will eat into your returns, so it’s really important to shop around.

Ultimately, most investors will have a mix of funds in their portfolio – some active, some passive. Beginners might want to start off with a passive tracker until they get their heads around the world of investing. Then later on they would supplement that with some actively managed funds to give them an extra edge.

Whatever you choose, do your research, be aware of the risks and have a long-term outlook. You’ll be beating inflation in no time.