Funds offer a simple way to invest in a broad array of assets and are often branded as being either active or passive.
The two types of investing offer a different kind of exposure to the market – the difference between them can be puzzling for new investors, but it is quite simple when broken down.
In this part of Trustnet’s first-time investor series, we’ll be explaining what active and passive funds are and why you might want to invest in each. If you’re still unsure of what a fund is, we explored them and how they offer diversification in our last segment.
Let’s start off with passive funds. Put simply, these are portfolios that aim to track an index, which is the average performance of a group of assets. For example, a fund investing in the UK might compare themselves to an index of the UK’s top 100 stocks, known as the FTSE 100.
A passive fund has no manager – instead, it simply tracks the performance of an index. It does not require any stock selection, hence the term ‘passive’.
Conversely, active funds are run by a manager who choose what assets go into the portfolio. They actively control what to buy and sell, hence the name ‘active’.
Managers look at the whole market and pick out what they think are the very best stocks available. The assets they choose then make up the fund, which they hope will beat the market.
Each fund has a ‘benchmark’ index that it is compared to, giving investors ani idea of whether they have successfully beaten the market, or whether its picks have performed worse than the overall average.
Passive funds tend to be a lot cheaper than their active counterparts, which charge a higher fee in order to pay for the labour of managers and stock analysts.
Passive funds also give investors a broader spread of assets than the typical active fund, which contains fewer names. This diversification can provide some security, but it can cause detriment to investors in some instances as indices can contain poor companies that remain in the group because of their size.
They may have fundamental issues that could cause a drop in its share price over the long-term, but passive investors will have no choice but to hold them because they remain part of the index.
Active funds have the benefit of managers avoiding these types of companies and can invest more freely in the smaller, up-and-coming companies of tomorrow, rather than being forced to buy historical winners.
Which should you buy?
Active and passive funds may offer different approaches to investing, but there is no reason why investors can’t hold both, according to Sarah Ruggins, head of multi-asset research at St. James’s Place.
She said: “For most investors, it is prudent to consider strategies across this spectrum rather than all or nothing, depending on their investment goals.”
Ultimately, whether you choose to invest in an active or passive fund depends on how much you’re looking to engage with the market.
If you want to be more dynamic with a concentrated selection of assets, active funds might be for you, while you might prefer a passive fund if you want to sit back and let the market run its course.
Ruggins said: “The important element for investors to consider when selecting between active and passive is whether they are comfortable simply participating in the market, or whether they are willing to pay more for the chance at outperforming it by taking additional risk.”