Active or passive investment

Types of investment

Active or passive investment

By Michael Trudeau

Article 2 of 4

Put us to the test

Our Test Labs compare features and prices on a range of products. Try Which? to unlock our reviews. You'll instantly be able to compare our test scores, so you can make sure you don't get stuck with a Don't Buy.

Active or passive investment

Should you use a stock-picking fund manager – or buy cheap tracker funds?

If you’re placing your money into an investment fund, there are two main strategies you’ll encounter – active management and passive management.

Debate has raged over the years as to which is the most effective way to invest your money and, when it comes to unit trusts and OEICs, your choice of actively managed funds heavily outweighs passive funds. There are more than 2,000 actively managed funds but fewer than 100 passive funds listed by the Investment Association. 

However, access to passive investment strategies has risen dramatically in the past few years with the increasing prominence of exchange traded funds (ETFs) as an option available for investors.

What is active management?

Actively managed investment funds are run by professional fund managers or investment research teams who make all the investment decisions, such as which companies to invest in or when to buy and sell different assets, on your behalf. They have extensive access to research in different markets and sectors, and often meet with companies to analyse and assess their prospects before making a decision to invest.

The aim with active management is to deliver a return that is superior to the market as a whole or, for funds with more conservative investment strategies, to protect capital and lose less value if markets fall. An actively managed fund can offer you the potential for much higher returns than a market provides if your fund manager makes the right calls. 

It also means that you have somebody tactically managing your money, so when a particular sector looks like it might be on the up, or one region starts to suffer, the fund manager can move your money accordingly to expose you to this growth or shield you from potential losses.

How does this differ from passive management?

Passive investment funds will simply track a market – and charge far less in comparison. The funds are essentially run by computer and will buy all of the assets in a particular market, or the majority, to give you a return that reflects how the market is performing. 

Find out more: Tracker funds and ETFs – our guide explains the pros and cons

What are the problems with active management?

Contrary to the impression you might get from the advertising produced by the funds industry, very few active fund managers are able to consistently outperform the markets they aspire to beat. For example, analysis of the UK All Companies sector at the end of 2010 showed that only 24% of actively managed funds managed to beat the benchmark stock market (the FTSE All Share) over the previous decade. 

Essentially, there’s a strong chance you could end up with a fund that fails to deliver you the return you could get by simply tracking the index with a passive fund.

One of the biggest drags on this performance is costs. For the privilege of getting an expert fund manager, you have to pay much higher fees than you would with a passive investment fund. The typical ongoing charge figure for an actively managed fund is 0.85%, rising to 1% in many cases; by contrast, passive funds can be held for as little as 0.1%. 

So, a fund manager has to deliver an extra 0.75% or more in annual return, as well as beat their benchmark index (the market that acts as a comparison for performance) in order to prove their value. This proves too challenging for most managers over the long term.

And in almost all cases, you still have to pay an annual fee even if your fund underperforms its benchmark. You might view this as acceptable if your fund returns 7% in comparison with 7.5% from the stock market, but what if it loses money? A loss of 2% could be increased to 3%, and you’d still be paying for the privilege. Actively managed funds that waive their annual fee if they underperform are vanishingly rare.

Should you invest in actively managed funds at all?

If you pick the right actively managed fund, you could make much more money than you would with a tracker fund or ETF. There are some very skilled managers, who have built up reputations of consistent high returns and can be worth the fees you pay for them. 

And, indeed, your investment needs and goals might require you to achieve higher returns, and a good active manager can, potentially, help you achieve these. However, with such an abundance of actively managed funds out there, knowing who will perform in the future can be tricky. Yesterday's winners are often tomorrow's losers and vice versa.

Some areas of investment are much better suited to active rather than passive management. Property funds, for example, buy commercial properties, and pay returns based on rental income and increases in capital value of the properties. A tracker fund simply cannot do this, and it may be valuable to invest in an actively managed property fund. 

An active manager might also be useful in more specialised areas, like technology, healthcare, smaller companies or emerging markets, where expert knowledge can help to seek out value.

  • Last updated: February 2016
  • Updated by: Michael Trudeau