What is active vs passive investing?
The goal is to “beat the market” - i.e. achieve a higher return than the average market performance. These funds often charge higher fees as they require more work to maintain, usually anywhere between 0.6% to 1.5%. The main benefit is that you don’t need to worry about making changes to your investment portfolio - instead, you have an expert doing all of that through a single fund!
By contrast, passively managed funds are those which track a specific index (such as the FTSE 100 and S&P 500) – the overall purpose being to “mimic the market”. For that reason, no one is hired to manage and monitor the fund and to buy and sell stocks as they wish, hence why they incur low administration costs
KEY TAKEAWAYS
- In an actively managed fund, a fund manager or team is hired to continuously monitor trade securities whilst a passively managed fund are those which track a specific index (such as the FTSE 100 and S&P 500).
- An actively managed fund intends to “beat the market” whilst a passively managed fund's goal is to "mimic the market".
- Actively managed funds incur a higher cost and can deplete your investments when they're not doing well.
- Passively managed funds have less potential to make significant returns, unless there is an economic boom.
Are active funds or passive funds better?
That really depends on what your financial goals are. If you’re looking to make significant returns (more than 10%) then an active fund might be a better option for your portfolio. That being said, once you factor in all the administrative costs, most actively managed funds fail to “outperform the market” the way they intend to. There exist a few successful funds, but they’re hard to come by.
Research shows that passive investments outperform active investments in the long-term, as they’re not subject to high fees, timing errors and inaccuracies. The market has historically increased 7 to 10% every year so by choosing a passive fund with low administration costs, you’re actually likely to make better returns.
If we look at data, we can see that investors are increasingly prioritizing passive ETFs over active funds. In 2013, actively managed equity funds attracted $298.3 billion, while passive index equity funds saw net inflows of $277.4 billion, according to Thomson Reuters Lipper. But, in 2019, investors withdrew a net $204.1 billion from actively managed U.S. stock funds, while their passively managed counterparts had net inflows of $162.7 billion, according to Morningstar.
Advantages of actively managed funds
- Potential to outperform the market: Outperforming the market and making substantial returns is an attractive notion to investors. There are some funds which have managed to achieve this, so it’s worth researching the fund’s historical performance.
- No guesswork: Actively managed funds are considered a good option for early investors who want to remove all the guesswork associated with investing. Having an expert to apply their analytical research and forecasts can feel like an attractive prospect.
Disadvantages of actively managed funds
- Higher fees: There are higher fees incurred, regardless of how well your fund is performing. If your fund underperforms by 2% one month, you’ll have lost 3.5% once you add on the 1.5% fee. Equally, if your fund is up 5% one month, you’ll only gain 3.5% once you factor in your fee.
- Underperform the market: Historically speaking, most actively managed funds don’t tend to outperform the market index. It’s therefore worth considering whether this type of investment is worth the cost.
- Impossible to predict a fund’s future performance: Reading historical data will not be a good indicator of how a fund will perform, making it almost impossible to predict!
Advantages of passive investing
- Low-cost fees: By following an index and not requiring an active manager to oversea investments, passive funds incur lower fees.
- Transparency: Since you’re tracking a specific index, you will always know exactly how well your fund is performing.
- Diversification: Investing in a passive fund allows you to diversify your portfolio through a single fund, covering a variety of sectors and industries.
- Less-time consuming: You don’t need to constantly strategise and make decisions about your holdings. This helps to remove a lot of the guesswork when it comes to your portfolio.
- Buy and hold: Long-term investors are able to execute a buy-and-hold strategy compared to active funds.
Disadvantages of passive investing
- Limited scope: Following a benchmark means there is no scope to modify holdings, even if the market is performing badly. So if the market performs poorly, so will your investments.
- Smaller potential returns: Unlike active funds where managers seek to outperform the market, passive funds will rarely achieve that meaning that returns are on a lower scale. Returns will only be higher if the overall market performance is higher – in other words, when there is an economic boom.