Hello everyone! As longer term readers will know, we’re big fans of investment funds – but one of the biggest (and longest running) debates in the investment world has been if an active or a passive fund is better.
In this article, we’ll explain the advantages and disadvantages of both and what drives each side of the argument.
As with all articles on the Wilderness, this is opinion and isn’t official financial advice (see our editorial policy for more). You need to do your own research for your own financial situation before investing, and if in doubt speak with a reputable financial adviser.
What is a fund and why do we like them?
A fund is a very efficient way of giving yourself exposure to lots of stocks! Buying a fund is effectively purchasing a small amount of many companies and if the fund manager is doing their job well they’ll have this carefully structured to allow to you maximise the benefit from the investments being diversified to a number of different companies.
Alternatively a fund might be quite focused towards a specific sector of the market (for instance a technology focused fund) which lets you get exposure to the sector, without forcing you to buy into one company.
Instead of buying the stocks outright, you buy a unit of the fund instead, the price of which is determined by the underlying stocks.
With this, we become less reliant on our investment fortunes being tied to only one company. That’s a good thing, as it protects us from adverse shocks or unexpected news and facing significant downside risk as a result. The structure of the fund means they can keep transaction costs down and invest in multiple shares with cheaper administration costs than if you did it yourself.
You obviously pay a fee for using the fund (something we’ll be talking about here) and you have to be careful as some funds have restrictions on when you can put money in or take it out, although that’s becoming slightly less common.
If you’re looking for a fuller range of investments you might consider, you can read our guide here.
What is the difference between a passive and an active fund?
It’s simply the method of how the fund is managed!
In the case of an active fund, the fund manager picks specific stocks to fulfil the objective of the fund (usually to get the best return possible).
In the case of a passive fund, the manager creates a basket of stocks which largely don’t change, except where they’re against the rule of the fund. That doesn’t necessarily make intuitive sense so let’s run through an example:
A passive fund might be designed to track the performance FTSE 100 as closely as possible. It will do this simply by investing in every FTSE 100 share, but if a share were to drop out of the FTSE 100, the fund would sell it and buy it’s replacement, a process that’s often automated.
A passive fund may be called an index fund (if it tracks a stock market index) or simply a tracker fund (either as an alternative name or it’s tracking another metric).
What are the advantages and disadvantages of an active fund?
We as humans rather like the idea of active funds on instinct. It feels logical and slightly reassuring that someone is doing painstaking research to carefully select the stocks they feel are the best investments out there.
At it’s best, this turns into the major advantages of an active fund:
- If a fund manager does their job well, they should be able to consistently beat the market, and provide you with a return that is in excess of a tracker fund because more care is given to the choice.
- A fund manager may be able to read a situation happening in the market based on experience allowing them to take advantage of specific situations to enhance profits.
There’s a few problems which we find in practice though which forms the disadvantages of an active fund:
- To perform the research and consider the investments is costly, both in terms of getting data and the sometimes quite expensive humans that review it! The net effect to you is that you have to pay for this via the fees charged for investing in the fund. Therefore, the fund doesn’t need to perform just “better in the market”, they also need to cover their own cost which can eat into your returns.
- Often we’d pick a fund based on prior good performance – “picking a winner.” However beating the market in a single or a couple of years can be down to pure luck, and picking the right stocks consistently is something many funds struggle with. Past performance does not guarantee future returns!
Unfortunately studies have shown whilst some active funds do extremely well, a lot can struggle to even beat the market. We’d always encourage you to monitor the performance of your investments and check you’re happy with them, but it’s not quite as simple as just “switch to one making money.”
Active funds that are losers now can become winners later, and vice-versa!
What are the advantages and disadvantages of a passive fund?
Well you have one obvious advantage that’s the opposite of the one above, and one that’s more of a structural point:
Advantages of a Passive Fund:
- It’s generally cheaper – because it’s just a largely static list of stocks, less research is needed and there aren’t so many administration costs from making changes to the portfolio. Plus, less humans are needed to run it.
- It’s very easy to target specific areas of the market, and you can combine funds (or have funds of funds) to get exposure to very specific elements of the market.
Disadvantages of a passive fund:
- As passive funds are designed to be non-reactive, it may mean a lack of reaction to specific scenarios, and miss out on outperforming the market. A change in the economic cycle is a good example of this.
- You can end up investing in some very poorly performing companies as part of the group that diversify, but hold back performance.
- Some passive funds focus heavily on the established company end of the market, and miss out on good (if potentially riskier) opportunities in growth investment.
So is passive or active investing better?
Well best possible outcome is a really good active investor that consistently performs better than the market and always covers their own costs is clearly the best option. It’s finding one that’s the problem.
When it comes to making a decision between the two, the arguments on cost aren’t to be underestimated – if Fund A costs 1.25% of your investments a year and one fund costs 0.25% a year, that’s actually quite a lot of performance that needs to be made up, and you often pay in a bad year anyhow.
When we look at empirical evidence of track fund performance research has shown that passive funds have tended to be the better performers after your account for the costs. However, the absolute best active funds were able to beat the passive funds by a large margin.
And whilst passive funds tend to be cheaper, it’s not always actually the case! Personally, I invest with Vanguard in their Lifestrategy funds which are active, but still beat most passive trackers on cost – I see this as rather a best of both worlds.
So as with many things in the investment world there’s no absolute rock solid answer and merit in both arguments. The key thing is to make sure you understand what you’re investing in, that it’s right for you and you understand the basic mechanics.
Are you an active or passive investor?
I’d love to hear if you’re an active or passive investor, if you’ve found that approach works for you and what led you to the conclusion! Just get in touch in the comments section below and let us know.
That also applies if you have a burning question, or think we’ve missed a key argument in favour of one of other (the investment world tends to get quite passionate about the topic!)