Active or Passive Funds
If you invest in a fund, your money is usually spread across a wide range of underlying investments with the aim of diversifying your portfolio - be it in shares, bonds, property or commodities.
The goal is to achieve balanced returns
However, it’s important to remember that the value of investments can fall as well as rise, and there’s a chance you could get back less than you put in.
Fund performance is usually judged by comparing it against a benchmark or index.
The benchmark is the performance standard. It varies by fund type and could be based on a broad market index such as the FTSE All-share; or asset specific, such as focusing on the aggregate performance of bonds; or segment-specific, for example focusing on the overall performance of companies within a specific sector, such as financial services.
Funds are generally divided into two types – active funds and passive funds.
It’s important to understand the key differences between these two types of funds.
Active funds typically have one goal - to outperform a benchmark.
Active funds aim to outperform their benchmark by relying on a fund manager making individual investment choices.
Active funds have fund managers.
Active funds have fund managers who use their expertise and large amounts of research to decide which investments the fund will hold. They adjust the fund’s holdings on an ongoing basis, in response to performance and changes in market conditions.
Fund managers are paid to manage the fund, even if the fund does not succeed in performing better than its benchmark.
Advantages of Active Funds
- Fund managers can spot opportunities for returns and seek ways to minimise the impact of a downturn
- Active funds aim to outperform their benchmark or the relevant market.
Disadvantages of Active Funds
- Active funds charge higher fees, including a fund manager charge as well as other ongoing costs
- Fund managers won’t always get it right – so the fund could potentially underperform against its benchmark and the wider market.
Costs of Active Funds
If you invest in an active fund you can expect to pay ongoing fees and charges ranging from around 0.65% to over 1% each year of your total investment in the fund.
A passive fund typically aims to match the performance of its benchmark.
The fund is designed to follow the performance of its benchmark, rising and falling in line with the market. Passive funds attempt to do this by:
Directly investing in everything that appears on the index that the fund is tracking - for example buying shares in proportion of all the companies listed on an index to track the performance of that particular market.
Indirectly investing in an asset by entering into an agreement with another party to mirror the movements in the asset price. If the price of the asset rises, the other party will pay the fund. If the price falls, the fund will pay the other party. There is a risk that the other party might not be able to pay the fund, if for example the other party was to go out of business.
Advantages of Passive Funds
- Passive fund charges are often lower than active funds
- Passive funds will very closely follow the performance of their benchmark without the same risk of underperforming due to fund manager investment choices that don’t pay off.
Disadvantages of Passive Funds
- Passive funds won't be able to reduce the impact of a market downturn as they will follow the index
- Passive funds don’t have the same opportunity to outperform and will not beat the benchmark.
Costs of Passive Funds
If you invest in a passive fund you can expect to pay ongoing fees and charges as low as 0.07% of your total investment in the fund.
As funds are usually a diversified investment, they’re often less risky than holding individual stocks and shares.
According to The Investment Association, the vast majority of funds are actively managed.1
Annual charges are higher for active funds than they are for passive funds.
Which to choose?
You don’t have to choose between active or passive funds; you might want to consider investing in both types of funds as a path towards diversifying your portfolio. Before you invest in a fund make sure you fully understand the fees involved and seek professional advice if you are unsure.
The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.
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1 Of all UK funds under management, active funds hold 74% of the total amount invested, while passive funds hold 23%. Source: Asset Management in the UK 2015-2016, The Investment Association Annual Survey, published September 2016.