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Home » Features » A guide to active vs passive investment

A recurring debate in the investment world is whether it is better to opt for actively managed investment funds or passive index trackers.

An actively managed fund will try to outperform the market, with a fund manager selecting the stocks that they think will increase in price by more than the index. Meanwhile, an index-tracking fund will simply try to provide broad market returns by matching a particular index as closely as possible. For example, a UK equity tracking fund might try to provide returns in line with the FTSE 100.

So, what are the benefits of the two types of funds, what is and isn’t in the investor’s control, and which different investment styles can be taken?

How is an index constructed?

Before looking at the two different types of funds, it is important to understand how an index is constructed.

Most stock market indices are ‘market cap weighted’, meaning the position of the company on the index is determined by the size of the company. For example, the FTSE 100 invests in the largest 100 companies listed on the London Stock Exchange, putting the most money into the largest company, the second-largest amount into the second-largest company, and so on. The S&P 500 in the US works similarly, as do most other mainstream indices around the world.

An index tracking fund will aim to provide a return in line with the index by buying the same proportion in each stock as the index holds.

The theory is that investing in this way represents the ‘average return’ of the overall market. Whilst some investors will do better than the market, some will do worse. Therefore, in principle, the active fund should return roughly the same as the index, minus costs.

Get the controllable under control

A common investing mantra is that the only thing we can control is what we pay for.

Investors can position their portfolios for particular economic environments, for example, if strong economic growth is predicted. However, there is also always a chance of getting it wrong. Even if an investor or fund manager gets an economic call correct, the individual companies may turn out to have stock-specific issues that weren’t anticipated.

Risk can be controlled to some extent by diversifying across different stocks or asset classes, but it is still possible to be caught out here if historic relationships between assets are not repeated.

By contrast, there is a great deal of control over costs, which are generally known in advance. By paying less for a particular fund, chances of a positive return are increased.

Costs are where index trackers have an advantage. If a UK index tracking fund charges 0.1% p.a. management fee, provided it tracks the index efficiently, the return is likely to be in the region of 0.1% below the index. However, an active fund may take 0.75% p.a., so needs to outperform the index by 0.75% p.a. just to keep up with it. So, an active fund manager needs to outperform by 0.65% just to return the same as a tracker that charges 0.1%.

Actively managed funds may carry other hidden costs as they tend to trade more than the index fund, which attracts dealing costs such as broker commissions and stamp duty.

What does the market know?

Advocates of passive funds will say that the market is pretty efficient.

Mainstream markets like the UK or US have tight regulations around company information and market-sensitive information must be released publicly so that all investors have access to it at the same time. Therefore, all known information about a company is already factored into the stock price.

When new information is released, it is difficult to react quicker than everyone else, especially in today’s landscape where algorithms make trading decisions in microseconds. However, actively managed funds may do better from an informational advantage such as smaller companies only being analysed by a smaller number of investors.

However, these efficiencies may not necessarily be translated into certain markets, such as emerging markets.

Investing styles

There has been academic research over the years as to whether there are particular types of stock that tend to outperform over time. There have been all sorts of factors that have been identified, such as momentum, value and growth.

To increase chances of outperformance, investors essentially need to take more risk than the average. For example, over the long term, smaller companies tend to outperform larger ones. If a £1bn company adds £1bn of value it will double in size, but a £100bn company adding £1bn of value has only added 1%. This is one of the flaws in market cap-weighted indices, which hold the most in the largest companies, but there is of course a greater risk that the smaller companies might fail so are riskier by nature.

Investment styles tend to go in and out of favour, which is why active funds rarely outperform every single market environment.

Diversification is key

Overall, the benefits of active vs passive investment will depend on the particular environment and market. Keeping a balance of investing styles will keep risk down, but it is wise to tilt towards different stocks depending on expected market activity. A passive approach requires less monitoring and detailed research, so it may be the best option for self-investors.

Historically, many passive investors will diversify their portfolio by holding perhaps 60% in equities and 40% in bonds, but this may be too simplistic. In recent times, equities and bonds have often moved in different directions, but this is not always the case.

In an environment where interest rates are going up, certain types of equities and bonds could struggle at the same time. Given this, diversification is key for investors, not only investment type and style, but also to diversify assets. This means holding assets such as property, infrastructure, and alternatives, all of which can only really be managed actively.

Established in 1995, Equilibrium is an award-winning Chartered wealth management company with a tailored and personal approach to financial planning services including investment management, IHT planning and retirement planning. Its purpose is to make people’s lives better by helping them to live the life they want; look after those they love and leave a powerful legacy. 

Please note this article does not constitute investment advice. Investors are encouraged to do their own research beforehand or consult a professional advisor.

Stuart Fieldhouse

Stuart Fieldhouse

Stuart Fieldhouse has spent 25 years in journalism and marketing, including as a wealth management editor for the Financial Times group, covering capital markets and international private banking, and as an investment banking correspondent for Euromoney in Hong Kong. He was the founder editor of The Hedge Fund Journal.

Stuart has worked at CMC Markets, supporting the re-launch of its global financial spread betting and CFD trading platforms. He is also the author of two books on trading, published by Financial Times Pearson. Based in The Armchair Trader’s London office, Stuart continues to advise fund managers, private banks, family offices and other financial institutions.

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