A major development in retail investing in recent years is the increased availability of vehicles which simply look to track the performance of a market. Thanks to their low cost, these passive funds have proved very popular and drawn money away from actively managed funds, where a professional stock picker makes the investment decisions.

In this article we flesh out what active and passive investing are and discuss their respective advantages and disadvantages. Most research suggests the majority of active managers fail to beat the market but there are some notable exceptions.

WHAT IS ACTIVE INVESTING?

Active investment involves a fund manager selecting stocks, bonds, property, and other assets with portfolio weightings which match their investment objectives.

The aim of active management is to outperform a benchmark, for example a specific stock market index. The investor pays a fund manager a fee to do this. Typically, the figure to look for is ongoing charges which can vary from around 0.5% or lower in some cases all the way up to 1.5% and beyond.

The way funds levy charges may vary so it is important to check the fund factsheet or contact the fund provider to uncover what the fees are in total.

Charges can reflect the management style, the asset classes being invested in and/or the prestige of the fund manager. It can also reflect the amount of money invested in a fund. Funds with lots of assets can usually afford to reduce ongoing charges in percentage terms.

Paying a higher fee to a fund manager doesn’t necessarily mean they will perform better in the long term. Paying out a high fee can have a significant impact on returns – as the crude example below shows – and this can really stack up over time.

WHAT IS PASSIVE INVESTING

Passive investment is where an investor buys a product such as an ETF (exchange-traded fund) or tracker fund based on a specific index. For example, a FTSE 100 tracker fund will track the performance of the top 100 companies.

While ETFs dominate the passive investing space there are traditional funds which also track an index for similarly competitive costs. For example, Fidelity Index World (BJS8SJ3) provides exposure to global developed market shares for 0.12% which is lower than the 0.2% levied on the comparable iShares Core MSCI World (SWDA) ETF.

Reflecting the fact that they are simply looking to achieve the return of an underlying market, fees for tracker funds are traditionally lower than those for actively-managed funds. Most passively managed tracker funds charge between 0.05% to 0.85%.

Typically, funds tracking plain indices like the FTSE 100 have much lower fees than those tracking more esoteric markets, assets or themes.

WHAT ARE THE ADVANTAGES OF ACTIVE INVESTING?

There are several advantages to active investing.

The fund manager will employ an active strategy regularly reviewing the fund’s portfolio, making adjustments as they see fit – for example buying or selling holdings, and monitoring the wider stock market movements - so you don’t have to.

Mark Ellis, fund manager at the Nutshell Growth Fund (BLP46Q1) – an actively managed fund – tells Shares: ‘We carry out regular portfolio rebalancing to uphold our commitment to investing in the highest quality companies at the best price relative to other opportunities.

‘This ensures sustainable performance. Our process is very research, quantitative and relative value trading based, using many tools and methods usually more prominent in the hedge fund arena.’

Ellis adds: ‘Active managers with a consistent process can outperform over the long run, especially boutique funds in the global space. These funds also tend to preserve capital in a risk off environment, as they can have significant exposure to quality companies which tend to outperform, higher cash holdings and also benefit significantly when there is a flight to the US dollar. By definition active share is likely to be higher (Nutshell Growth fund is typically around 90%) which means they could also offer investors diversification benefits.’

‘Passive funds ignore the underlying expected returns, disregard valuation and only rebalance at infrequent intervals. At Nutshell we compare like-for-like across the globe and select stocks which offer exposure to important factors for the best possible price.

‘We sell when expected returns fall due to price appreciation and buy when expected returns increase. We can react instantly to new company specific news or extreme price action. Active managers can be nimble, allocate more defensively during turbulent times, and increase exposure during bull markets.’

WHAT ARE THE DRAWBACKS?

One of the biggest turn-offs for investing through an active fund  is the higher annual charges (depending on the type of portfolio the fund manager is running) compared to passive investing.

Another disadvantage of active investing is that the investor is very much at the mercy of the fund manager’s performance and their ability to navigate any volatility within the global stock markets.

Before you embark on buying an active fund it is worth looking at its performance over at least a five-year period along with that of its managers.

Saying that, past performance is not necessarily a reliable measure of future performance.

One of the advantages of passive investing through a tracker fund is the lower fees. ETFs also enjoy the transparency of being traded on a stock market. You can see a full list of their holdings and unlike traditional open-ended funds you instantly know the price you’re trading at rather than within 24 hours of making the trade.

WHAT SHOULD INVESTORS DO?

This is not an either/or situation: it’s perfectly possible to have some passive funds as building blocks of a portfolio alongside some actively managed funds. But it’s important to keep tabs on any active funds in your portfolio to judge if they are justifying the fees they levy.

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