What is an active fund?
An active fund is one which involves a fund manager or team who decides where to invest your money. The fund manager’s aim is to generate returns that exceed those that would be produced if the fund simply followed the performance of a market index such as the S&P 500. The fund manager will spend time researching which assets to invest in, often making regular adjustments to the make-up of the fund by buying and selling its investments to maximise value.
What are the advantages of active funds?
Potential for greater returns
If the investment decisions of the fund manager prove successful, an active fund has the potential to generate higher returns than both the index it’s being measured against and those achieved by passively managed funds.
Active funds are flexible in responding to changes in the market. Fund managers may spot new investment opportunities that potentially offer greater returns. They may also be able to mitigate against market downturns, for example, by divesting from specific stocks that dip in value and reinvesting elsewhere.
What are the disadvantages of active funds?
Higher management fees
The fee to manage an active fund is typically much higher than that of a passively managed fund. Active fund fees can exceed 1% of the value of the fund per year. The accumulation of the fund’s management fee, in addition to other ongoing charges over time, may end up representing a significant portion of the fund’s overall value.
Fund performance is not guaranteed
Despite the expertise of using a fund manager, there’s no guarantee that the investment choices they make will achieve their aim of outperforming the market. This approach relies on the particular strategy and investment-picking decisions of the fund manager. Even if a fund manager has been successful in the past, they may not be able to replicate that success for every fund they manage or deliver consistently for the same fund.
What is a passive fund?
A passive fund will track the performance of a broad market index such as the FTSE 100 or S&P 500. Its aim is to produce a return that matches the performance of that index. Unlike an active fund, the manager of a passive fund doesn’t choose specific investments, instead, its underlying investments will mirror that of the index being tracked. This means the fund will buy the same investments in the same quantities as that held by the index.
What are the advantages of passive funds?
Lower management fees
Passive funds typically have low annual management fees when compared to active funds as there’s no need for fund managers to research or buy and sell investments.
Reduced risk of underperforming
As passive funds aim to replicate market performance by holding the same funds as the market index they follow, they won’t significantly underperform that index. Returns on investment will be very close to the index they track, even after deducting account management fees.
Passive funds track a broad market index so they may be invested in hundreds or thousands of companies. This means the fund’s growth is not reliant on the performance of just a few investments and should be less impacted if one investment in the fund performs badly. However, there are a variety of passively managed funds which only track the index of a particular sector of the market, such as technology companies, and so the risk is slightly higher.
What are the disadvantages of passive funds?
Returns won’t be above the market performance
Passive funds aren’t designed to beat market rates of return. The fund’s value will rise and fall in line with the index being tracked.
If any investment within a passive fund performs badly the fund manager won’t be able to exit from that investment and move into a different one. This makes passive funds less agile in responding to market volatility or to poor performance of individual stocks.
Pension fund investment
Most pension funds use a passive management approach, including most of our plans here at PensionBee. As a pension could be held for many years, passive investing can enable your pension to grow over the long term and can be beneficial for riding out periods of market volatility.
Some investment approaches blend elements of both passive and active management. For example, our 4Plus Plan actively manages your funds and adjusts how they’re invested on a weekly basis. It does so by investing in a broader index of companies rather than the fund manager choosing to invest in individual companies.
Which approach is right for you?
Deciding which approach to use will depend on a variety of factors such as an individual’s appetite for risk, confidence that an active fund manager will outperform the market (and therefore justify the associated higher management fees), and personal goals among other factors.
The flexibility of active funds makes them better suited to take advantage of short-term trading opportunities. Despite this, it’s almost impossible to predict how the markets will perform, making it very difficult to choose the right time to buy and sell investments. As such, active funds may not avoid market downturns let alone outperform the market or even passively managed funds.
Passive funds, in contrast, are generally understood to be better suited to long-term investment and research has shown they generally outperform active funds over the long term. Additionally, their lower management fees can mean better overall returns compared to the higher charges of active funds.
Neither active nor passive funds will guarantee returns but each can form part of a broader investment strategy. Given the key strengths of passive funds, they generally lend themselves better to long-term investments such as pensions.
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.
Last edited: 20-10-2022