The distinction between ‘active’ and ‘passive’ forms of investment management represent a difference in approach taken by professional fund management companies. Don’t try to characterise your own personal investment approach as being either one, because that doesn’t make sense. This article will help you identify a fund as being either actively or passively managed, explain why it matters, and help you decide when best to use each of them.
An actively managed fund is one where a team of analysts and fund managers does research and analysis to identify the best possible investments for their fund, in line with the fund’s stated objectives and constraints. For example, the team behind an actively managed U.K. equity fund will seek to identify the 30-50 best stocks in the U.K. and invest in them. You would not expect the fund in this example to hold stocks of American companies. Not all active U.K. funds are going to choose the same stocks, however, either because different fund managers have differing opinions or because their funds have different objectives and constraints. As an investor in their fund, you will pay the management company a fee for managing your money, typically in the realm of 1-1.5% of the amount you invest, per annum.
A passive fund is one which seeks to track a pre-defined index or benchmark and does not try to beat it. Benchmarks and indices are common in the investment industry because they help us to measure and compare performance and keep track of the markets. For example, a passive U.K. equity fund may seek to track the FTSE100, which is a well-known index of the 100 largest companies in the U.K., compiled by the London Stock Exchange Group. It will not seek to identify the best companies within the FTSE100; it will simply buy them all in proportion to their weight in the index. Since fewer resources are required – these days much of the process is automated – the annual management fees on passive funds are much lower, typically in the realm of 0.05%-0.15% per annum.
To directly compare the two U.K. equity funds in our examples, let’s assume that the active fund is benchmark to the FTSE100. That is, it is trying to beat the performance of the FTSE100. In that case, net of all fees, you will have been better off investing in the active fund if it outperforms the passive fund by about 1% p.a. (the fee differential).
Of course, you can’t know in advance whether the active manager will outperform their benchmark, which makes investing in an active fund a bit of a gamble. In framing the decision about whether to take the active route for a particular part of your portfolio, ask yourself – how important to me is ‘beating’ a benchmark or performing better than others? If not important at all, your portfolio should be mainly comprised of passive funds. Indeed, that’s our approach at To the pound.
Having said that, there are some exceptions where we recommend choosing the active fund, and we provide a brief reason below. If you want more detail on our reasons, please comment or send us a message.
- Corporate bond funds, because indices typically give higher weight to the companies that issue the most debt, causing passive funds to be overly invested in high-debt companies
- Emerging market debt funds, because of the reason above but also because there are more ‘inefficiencies’ in emerging markets for active managers to harvest and earn extra returns from
- Emerging market equity funds, for the above reason
- Small stock funds, because smaller stocks are less well-researched and so can be mis-priced, giving active investors an opportunity to outperform.
On top of your core portfolio allocations to funds, both actively and passively managed, you may be adding a ‘satellite’ layer to your portfolio, undiversifying into a handful of individual stocks. This is obviously an ‘active’ decision of yours, so it ultimately increases active risk in your portfolio. However, since you probably aren’t measuring your overall portfolio against an overall benchmark, the extent of ‘active risk’ can’t really be measured. Just think of it like this: I’ve increased the potential for human error in my portfolio. Active risk is just like any other risk: it might pay off, or it might not.
What active managers actually go through to manage their funds is not covered in this article. Elements of what they do are covered piece by piece in various articles across the site, but since every active manager will take a different approach, it’s not really possible to summarise what the average active manager really does. But please comment if you think any further clarity could be helpful.
We hope this article was useful in helping you understand the difference between active and passive fund management approaches, and when to use each of them in your portfolio.
We refer to lots of linked posts in this post. We hope that by following the links you can answer any questions you might have, but if anything is unclear in this post, or you have any questions relating to anything investment-related, please submit comments or questions in the section below and we’ll do our best to answer them.
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