Both active and passive funds allow you to buy a basket of different investments in one single purchase.
However, they do have one important difference.
An active fund employs a fund manager to invest in stocks that might outperform the stock market as a whole. In contrast, a passive fund simply attempts to replicate the performance of an index, for example the FTSE 100, rather than outperform it. Passive funds are often known as ‘tracker funds’ because their aim is to track an index.
An active fund attempts to deliver a return that beats the market as a whole, and hires an expert (fund manager), or team of experts to achieve this. Experts may react to economic events, and may be skilled at picking certain stocks.
Research shows that active managers can absolutely beat the market. Figures from BMO Global Asset Management showed that the best performing active fund in the UK beat the index by 3.1 times over 10 years.
However, active managers can underperform as well, with figures from S&P Dow Jones showed that 99 per cent of actively managed US equity funds sold in Europe failed to beat the performance of the S&P 500 in the ten years to 2016.
As well as the potential for underperformance, a major downside of an active fund is the cost. As you are effectively hiring an expert, or a team of experts, to make the tough investment choices, you’ll indirectly pay more for using the service through the fund manager fees. These charges can eat into your returns, so even if your stocks do outperform the market you can end up paying more through fees.
Passive funds, on the other hand, tend to be far cheaper, since a computer can effectively manage the funds. A computer, however flashy, doesn’t require a salary. These funds can never outperform the market, as the objective of these funds is to replicate the market, rather than outperform it, you may lose the chance of any excess returns that an active fund might provide.
On the other hand, the chance of underperforming the market is extremely low. Passive funds can be bought either as traditional funds (also known as mutual funds) or as exchange traded funds (ETFs), and will cost you a lot less than an actively managed fund.
Passive funds may actually be more diverse than active funds, since if they track a big index, like the FTSE 100, they will effectively attempt to replicate the performance of every stock in them.
Whether you choose a passive or an active fund, you will maximise your chances of success by doing your research first. Some tracker funds are cheaper than others, and if your only criterion is that the fund tracks an index, such as the FTSE 100, then you may as well pay as little as possible.
It’s also important to understand how the fund tracks the index. Does it own every stock it is tracking, or does it rely on contracts with third-parties to track them? If it is the latter, you need be confident with the safety of the third-parties as well as the fund itself.
If you choose an active fund, you can check past results (though it is no guide to future performance) to see how well the fund manager has performed. There will also be interviews with fund managers available in many cases, and you will be able to see whether the fund has beaten its benchmark in recent years.
It’s not always as clear cut as choosing one or the other, though. If your aim is to create a well-diversified portfolio, then holding both active and passive investments might well be the most appropriate way for you to achieve this.
Use our search tool below to see the active and passive funds available to invest.
Access a wide range of global investments in this flexible, unrestricted account.
Take advantage of tax free investing with our Stocks and Shares ISA today.
Selftrade does not provide investment advice. This article is the authors view and is not the view or opinion of Selftrade and Selftrade accepts no liability for any loss caused as a result of the use of this information. The opinions expressed are those of the author at the time of writing and should not be interpreted as investment advice.
The value of investments can fall as well as rise and any income from them is not guaranteed and you may get back less than you invested. Past performance is not a guide to future performance. We do not provide advice or make recommendations about investments. If you have any doubts about the suitability of an investment, you should seek advice from a suitably qualified professional adviser.