What are active and passive funds?

What you’ll learn:

• What the main differences are between active and passive funds
• Why you might choose one type over the other
• How active and passive fund charges vary.

When you invest in a fund, your money is spread across a wide range of underlying investments, which are overseen by a fund manager. It’s their job to run the fund in line with the stated investment objectives, meeting declared targets in order to deliver a profit for investors.

Funds are generally divided neatly into two types – active and passive. Both types aim to make money from whatever assets they hold – be it shares, bonds, property or commodities.

Active funds

The job of an active fund manager is to pick and choose investments, with the aim of delivering a performance that beats the fund’s stated benchmark or index. Together with a team of analysts and researchers, the manager will ‘actively’ buy, hold and sell stocks to try to achieve this goal.

However, there's never any guarantee that even the most talented fund manager will pick investments that will outperform on a regular basis. All investments are at the mercy of market conditions and sentiment so they could rise or fall in value. Some promising shares may nose-dive one year only to rebound the next. The best active managers are the ones who can navigate market volatility year-in, year-out. But many fail to achieve this, so if you’re looking at going down the active route, look at a manager’s long-term track record across a variety of market conditions but keep in mind that his past performance isn’t necessarily a reliable indicator of future performance.

The cost of active investing

Investors in actively managed funds will have to pay higher annual charges for the expertise of the fund manager, usually anywhere between 0.6% to 1.5%, but sometimes more, depending on the type of portfolio they’re running. It's up to you to decide whether the cost of a fund investment is worth the potential returns you could receive.

Passive funds

Passive or ‘tracker’ funds have a different aim altogether. Their main job is to deliver a return that’s in line with the market – they don't have to outstrip it, they simply replicate the movement of the market they’re tracking.

One of the most tracked and quoted indices is the FTSE100, which is an index of the UK's 100 biggest companies based on share value. A tracker fund will buy shares in all 100 companies and in the same proportions as their market value. The value of the fund therefore, will move in line with the change in the value of the FTSE100 Index.

Because passive fund managers don’t have to pick which investments to hold in their funds, you'll never get away from the fact that your return depends entirely on the performance of the index being tracked. Therefore, if the market falls, so will your fund. An active fund manager, in contrast, may be able to react to any market tumble by pulling out of troubled sectors and looking for better opportunities elsewhere, though of course if they misjudge it, they might lose.

Lower costs

In short, passive fund management delivers a return in line with how the tracked index performs. A key reason why this type of fund appeals to investors is because it offers them complete access to the markets that these funds mirror at a low price when compared to active funds. Some passive funds for example carry an annual management charge as low as around 0.1%. But it’s worth bearing in mind that passive funds will always marginally under-perform their index once costs are taken in account.

An open race to returns

Even though the aims of both types of fund management are quite different, the reality is that each can throw up some surprises. There could be years when active fund managers fail to beat the market. The stocks picked might not perform well enough. In this situation, passive funds could deliver higher returns. It's this uncertainty that ensures the active versus passive funds debate continues to run and run. The common argument among experts is that passive funds can work well for ‘efficient’ or very well researched markets such as the FTSE100 or the S&P500 in the US, while less established and typically more volatile markets such as those found in emerging markets, such as India or China for example, need the expertise of an active stock-picker. Which route is right for you, will be entirely down to your investment goals and risk tolerance. Whichever option you choose, remember that your investments can still fall in value as well as rise and you might get back less than you invest.