Should my investments be chosen by a computer or a human?

When you choose to invest, one of the first decisions you make is if your money will be invested actively or passively.

But what is the difference between the two? In short:

• An active fund means that the investments are hand-selected by a fund manager.
• A passive fund means that your money will be invested in a fund that follows a specific index, like the FTSE 100 or the S&P 500, and invests in a large group of companies or other assets across that market, using an algorithm. Essentially, it’s a computer following a set of rules.

For example, if an active fund invests in the UK, the manager will analyse companies across the UK stock market, meet with members of a company, and decide if that is a stock the manager would like to hold. If it is, the shares will become one of the investments in the portfolio, and the manager will decide how large of a percentage it will make up. So, if the manager has a lot of faith in the company, they may decide that 5% or 10% of the fund’s assets will go into that stock. Active fund managers usually hold a slightly smaller pool of stocks, that can range from 25 up to hundreds.

A passive fund has a different selection process. Instead, the fund will choose an index, such as the FTSE 100, which holds the largest 100 companies listed in the UK. The fund will then invest in the same companies that feature in the index. They will also usually follow the percentage allocation of the FTSE 100, meaning the largest companies by market value will get the largest weighting. This is called ‘tracking’ an index.

Passive indices can hold a hundred companies, or they can hold thousands. But usually, they hold a wider range than an active fund in the same sector.

How do I know if a fund is active or passive?

There are a few tell-tale signs to identify if a fund in which you’d like to invest is active or passive. The most obvious is the name: if your fund has something in its title that includes ‘index’ or ‘tracker’, it is mostly likely a passive fund.

The next thing you may want to check is the fund’s fee. You can do this by using AJ Bell’s fund screener tool. Just click on the fund you’d like to research, and you will see a page of information on that fund. Typically, funds that have a low ongoing charge fee will be passive. On average, the charge for a passive fund is 0.15%, according to Morningstar, but this can vary greatly, so it’s not a hard and fast rule. Active funds averaged a fee of 0.9% per year.

The most foolproof way to identify if a fund is passive or active is looking at its KIID document. This will be found on the fund’s page and usually has a section at the beginning of the document called ‘investment objectives’. Under this, it will often have a bullet point that says if the fund is tracking an index (meaning it is passive), or if it is actively managed.

Are active or passive funds a better investment?

There isn’t a definitive answer to this question and it’s important to remember that what’s done well in the past isn’t guaranteed to also do well in the future We note that in the past 10 years, active funds have had a difficult time performing as well as passive funds. Just one third of active funds in seven key equity sectors beat a passive fund in that same sector, according to research by AJ Bell at the end of 2024.

A lot of this difference is because of how strongly US companies like Nvidia and Microsoft have performed in recent years. Because global and US indices almost always held these companies, they automatically got a big boost. But if an active manager did not pick these companies, they would have a difficult time keeping pace with the growth. If you don’t factor in funds that are invested globally or in North America, then 44% of active funds have outperformed passive ones.

Another element is how much you are willing to pay in fees. As mentioned earlier, passive funds typically have low fees. Active funds tend to have higher fees, and it is up to you to decide if you’re willing to pay that extra amount for the possibility of returns that beat the market.

One way that people sometimes decide if an active fund is worth the fee is by looking at the past performance of that fund manager. But past performance is not an indicator of future returns, so even if you feel that you’re paying more for higher-quality management, there’s no guarantee that your money beat the market, let alone grow at all.

The bottom line? If you choose a passive fund, you will not outperform the market but should stay in line with it. If you choose an active fund, you have the possibility to underperform or outperform. Your choice doesn’t have to be either or. You can diversify by putting some money into both types of funds and see what you prefer with time.