Active vs Passive Funds – Which Are Best?

Ever since the late, great Jack Bogle – founder of Vanguard – launched the first index-tracker fund in 1976 a debate has raged in the investment world over which is best – active funds or passive ones. While the passive approach tends to get the backing of academia and has certainly attracted the most money in recent years, investors large and small still invest trillions into active funds.

So which is the best way to achieve your investment goals – active or passive?

What’s The Difference?

Actively-managed funds are run by professional managers who use their knowledge, experience and resources to make investment decisions. They’ll scour the thousands of shares, bonds or other investments on offer and select those they believe will deliver the best returns in line with the fund’s objectives.

Passively-managed funds, otherwise known as index-trackers, keep things simpler. They either invest in all (or nearly all) the constituents of a market index, or invest in a way that aims to mimic the index performance as closely as possible. So for example, a passive fund could invest in all the companies, and in the same proportion, as the S&P 500 or FTSE 100.

More management goes into the active approach, including well-paid fund managers and usually a team of analysts to support them. That usually makes them more costly to run and so active funds are typically more expensive than passive ones. To help offset costs and keep them even lower, index-trackers sometimes use tactics such as lending stocks in return for a fee.

This brings us to a major difference between active and passive funds – charges. The average active fund charges around 0.9% of the amount invested per year, whereas passive charges are a fraction of this at around 0.15%, and in the USA are often even lower.

Another big difference between them is the number of positions within each. Active funds typically contain anywhere from 25 to 250 individual investments. As passives usually invest in nearly every position within an index their holdings can sometimes run into the thousands.

Active: Pros and Cons

Actively-managed funds offer the potential to perform better than their benchmark. By selecting what the manager believes are the best investments, they could end up generating higher returns. There’s a catch though. There’s no guarantee that’ll happen and the fund could do worse if the manager’s selections don’t go to plan.

Active managers can also make economic or market forecasts, such as predicting a recession or crash, and adjust the fund to take advantage or offer better protection. They can also get this wrong though, or may even make the right prediction but get their timing wrong, which can be just as bad as being wrong.

Actively-managed funds can be better at offering more specialist investment themes, such as an income focus or ethical investing. If there’s no index available to track these things an index-tracking fund doesn’t have anything to copy.

Example Performance of Active and Passive Funds

Passive: Pros and Cons

While passively-managed funds won’t ever do better than their benchmark index, a lot of academic research and real-world evidence shows they still usually perform better than active funds. A big part of that is to down costs – all things equal a lower-cost fund will deliver better returns than a higher-cost one.

The often-overlooked caveat to this is most of the research focuses on US markets – the most heavily-analysed in the world, which makes them very difficult to beat. Outside the USA though active managers tend to have higher rates of success.

Unlike active funds, which offer no guarantee of beating their benchmark, you know what you’re getting with index trackers. If the index goes up, a passive fund will also go up by broadly the same amount. Of course if an index falls, it’ll go down with it too.

Diversification is another big benefit of passive funds. As they invest across the entire index there’s no better way of ensuring diversification, which in turn should help diversify investors’ portfolios too.

Active or Passive: The Verdict

While many investors position themselves firmly in either the active or passive camp, we prefer to take a more balanced approach. There are benefits of each, so rather than select one type or the other we like to blend both active and passive funds in our portfolios to get the best of both worlds.

Index trackers are used to ensure our portfolios remain really well diversified and help keep overall portfolio costs down. We also thoroughly research the thousands of active funds on offer to select those that have consistently delivered index-beating results and, more importantly, which we believe can keep up their strong returns for years to come.

So active versus passive – we’ll call this one a tie. No doubt the debate will continue to rage on but ultimately, with a sensible and disciplined long-term approach, you can achieve excellent results with either one.