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28 Nov 2022

Active or passive funds: which is the best option for investors?

Steve Hart

Steve Hart | Senior Investment Director

Passive funds are cheaper, and the majority of active funds underperform their benchmark. Is the answer as simple as it appears?

 

If we were to boil down all the intricacies of investing in the stock markets, there are really just two basic strategies:

  • Some investors look to make gains by investing in tracker funds that aim to make gains from the rises and falls of the markets.  The long-term trend of most investment markets is generally upward and although gains are not guaranteed many investors believe that this is a cheap and diversified way to invest. We call this passive investing.
  • Other investors aim to beat the market - outperforming when the market is strong, and minimising losses when it is weak - by trying to predict these movements and buy and sell accordingly. We call this active investing.

The passive approach has grown in popularity enormously over the last decade or two, largely because it is the cheaper approach.

Active investing involves investing in funds where the fund manager selects investments with the aim of outperforming the market be it a benchmark or index. Naturally, there is an expense attached to the team’s skill and experience. A passive fund simply buys every stock in the index and then methodically adjusts the positions to reflect the movement in the share price, simply incurring the cost of accessing the market.

However, passive investing comes with limitations. As the price of a security goes up, a passive fund can't take profits or buy more of this successful investment, as an active fund can. Equally, as the price goes down, the passive fund cannot sell to avoid further losses or buy more to take advantage of a lower price. So, there are advantages and disadvantages to both strategies.

The choice between active and passive investing can hinge on:

The type of investments one chooses

Passive management generally works best for easily traded, well-known holdings like stocks in large U.S. corporations. But in certain niche markets, such as emerging-market and smaller company stocks, infrastructure and private equity, where assets are less liquid and fewer people are watching, it is possible for an active manager to see opportunities.

Market conditions

Active strategies have tended to benefit investors more in certain investing conditions whilst passive strategies have tended to outperform in others. For example, when the market is volatile or the economy is weakening, active managers may outperform more often than when it is not.

Conversely, when specific securities within the market are moving in tandem or equity valuations are more settled, passive strategies may be the better option. Market conditions change all the time, however, so it takes an informed view to decide when and how much to skew toward passive as opposed to active investments. 

So, which is better?

Quite simply, both have their benefits when constructing a well-diversified portfolio which is precisely why we believe both have a role to play in effective portfolio management.

By nature, passive funds cannot outperform the market they invest in. Active funds can, sometimes exceptionally, and this is their main strength – but many do not. In fact, the majority underperform their benchmark. This presents a challenge when including them in your portfolio. 

Choosing the right active funds

In the active space, at Investec Wealth & Investment, we aim to choose the best of the best selecting the optimal funds for a given sector or geography and consistently monitor not just the fund performance but other metrics as well, including process and governance.

Through our years of experience researching active funds, we believe identifying successful funds relies on the avoidance of behavioural biases, qualitative research, direct access to fund managers, continual assessment and a value judgement demanding the cheapest share class available to us. To find out more, please feel free to get in touch.

It's important to remember that with both options, the value of investments and any income from them is not guaranteed you may get back less than the amount invested.

About the author

To contact or read more about Steve Hart, visit his bio here.

Investec Wealth & Investment (UK) is a trading name of Investec Wealth & Investment Limited which is a subsidiary of Rathbones Group Plc. Investec Wealth & Investment Limited is authorised and regulated by the Financial Conduct Authority and is registered in England. Registered No. 2122340. Registered Office: 30 Gresham Street. London. EC2V 7QN.