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Active and Passive funds are the chalk and cheese of investment world but in my experience, many investors aren’t that familiar with the basic concepts.

Which approach is right for you?

Square one

So, you’ve taken the decision to invest some money or perhaps you’re reviewing your pension strategy.

With the help of your adviser, you set some long-term goals, devised a financial road map and agreed a risk strategy that you’re comfortable with.

From there, your adviser will match an investment framework (asset allocation) to your chosen risk profile. This determines how your pot is allocated to different types of investments e.g. global shares, property, government and corporate bonds.

So far so good, but then your adviser asks if you’d prefer to pursue an Active or Passive fund strategy. What’s the difference?

Actively Managed Funds

Active fund managers make investment choices they believe will help the fund to beat a chosen benchmark. A fund manager investing in UK stocks and shares may, for instance, look to beat the FTSE 100 Index, as this is a commonly used measure of the UK share market.

Active managers, supported by a team of analysts, use their expertise and research to decide the mix of investments the fund will hold based on their view of future market and economic conditions. They will adjust the fund’s holdings on an ongoing basis to reflect changes in their forecasts or predictions.

Advantages If the fund manager makes consistently good stock decisions (only ever known in hindsight), there’s potential to achieve higher returns than the market.
Disadvantages Active funds tend to charge higher management fees and trade more frequently. These charges eat into your investment returns.

Beating the market isn’t easy. Many studies show that only 1 in 5 active fund managers beat their benchmark over most 5 year periods.

The higher management charges are payable regardless of whether or not the manager beats the benchmark.

Whilst a fund manager’s track record is a fair indication of their skill, it’s impossible to predict if they’ll continue to perform in future.

Passive Funds

Also referred to as index-trackers, passive funds simply aim to replicate the performance of an index or benchmark.

As with the previous example, a passive fund looking to track the UK share market might opt to replicate the performance of the FTSE 100. But instead of chopping and changing the underlying holdings, a passive fund aims to hold the same shares in the same proportions as the index.

Rather than spending time, effort and money trying to find the needles in the haystack, a passive investor just buys the whole haystack.

Advantages Management charges are much lower than active funds and have less impact on your investment returns.

 

Unlike active management, passives don’t rely on forecasts or predictions, so there’s little risk of underperforming the market.

 

Passives have been more reliable and outperformed most active funds, particularly over the past 10 years.

 

Disadvantages Passives offer little opportunity to reduce the impact of market downturns. If the FTSE 100 falls 10%, then you can expect your UK tracker to fall broadly by the same amount.

 

There’s zero opportunity for market outperformance; you simply receive the return the market organically generates (minus some fund costs).

 

Which is best?

As with many financial decisions, the choice of strategy ultimately depends on your financial objectives, your overall tolerance for risk and your general beliefs about the world:

  • Would market outperformance materially improve your life? e.g. enable you to retire earlier.
  • How would underperformance affect your plans? e.g. having to retire later or cut back your spending.
  • Do you believe that human beings can reliably and consistently predict the future of markets, companies and economies?

Final thoughts

This is an important decision, but thankfully it’s not one that should make or break you provided you’ve got some basic building blocks in place:

1. A Financial Plan

A sound financial plan or cash flow model will factor-in all manner of worst case scenarios. This should give you a pretty good idea of the returns you need to achieve over time, whether you need to beat the market and you’re able to tolerate the risk of underperformance.

2. Asset Allocation

Research shows that approximately 80% of the return from a portfolio is determined by its asset allocation. The underlying active or passive strategy can enhance or compromise these returns but it’s comforting to know that the main driver is the asset allocation itself.

As with many things in life, people tend to become wedded to a particular philosophy. But if you have no feelings or views either way, there’s absolutely nothing wrong with sitting on the fence and blending the two approaches, so that you get the best (and worst) of both worlds.