The benefits and risks of passive investing

What you’ll learn:

• What the main types of equity and bond funds are
• What the difference is between active and passive investing
• What multi-asset and multi-manager funds are.

Actively managed funds still dominate the world of investing but the popularity of passive investments is rising fast. Latest figures from The Investment Association show that the amount of money invested in computer-run index trackers in the UK amounts to more than £150bn. We look at what you need to know about passive investments.

What are passive funds?

Passive funds track the performance of a particular market or index, such as the FTSE 100. As well as unit trusts or open-ended investment companies (OEICs), passive funds can also be stock market listed exchange traded funds (ETFs). What they all have in common is that they typically hold all the assets in the index they’re tracking, or a representative sample.

Crucially, most passive funds are operated automatically rather than by a fund manager, which dramatically reduces their running costs.

Much of the debate between active and passive strategies comes down to this issue. Essentially, whether it’s worth paying the higher costs levied by active fund managers or whether you’re more likely to enjoy greater rewards in the long run by sticking to cheaper passive vehicles.

One of our principles of investing is that you should only move away from passive investments if you have good reason and fully understand the total cost incurred.

What’s the difference in terms of costs?

In many cases, investors pay annual charges of around 0.75% a year for actively managed funds. In contrast, some passive funds charge less than 0.1% a year.

The difference between the figures may appear small but over time their impact on your returns can be considerable. Take the following example, bearing in mind that these figures are based on a simplified example and are for illustrative purposes only – consistent returns over a prolonged period are very unlikely.

Let’s say you invested a £10,000 lump sum into a passive fund paying a total of 0.1% a year. Assuming you enjoy 4% growth every year, your initial investment would be worth £21,493 after 20 years.

However, the same amount invested in an actively managed fund with a 0.75% annual charge would grow to just £18,959 over the same period once fees have been deducted. That’s a difference of almost £3,000 just as a result of the fee.¹

Active versus passive funds

Critics of passive investing say funds that simply track an index will always underperform the market when costs are taken into account. In contrast, active managers can potentially deliver market-beating returns by carefully choosing the stocks they hold.

It’s also commonly argued that passive strategies can’t shield investors from periods of volatility. After all, if the market a particular fund is tracking takes a dive, so will the portfolio’s value.

But supporters of passive investing argue that many active fund managers fail to consistently beat the market over the longer term. And trying to pick the ones who will is extremely difficult, as a manager’s past performance should never be viewed as indication of their future returns.

Even Warren Buffett, the world’s most famous stock picker and CEO of Berkshire Hathaway, has previously praised passive investing.²

Given that developed markets such as the US and the UK are so widely researched, it’s particularly difficult for managers to spot opportunities that others have missed, so opting for a passive fund could make more sense. In contrast, regions that aren’t as well known, such as emerging markets, are generally the subject of far less analysis. In these areas, markets tend to be less efficient and many have suggested that the specialist knowledge and experience of a fund manager might be beneficial in hunting out attractive assets.

Find out more about active and passive funds

The rise of smarter strategies

Passive investing continues to evolve. Many fund groups are now offering smart-beta or strategic beta ETFs, which aim to bridge the gap between active and passive investing by using sophisticated stock-picking strategies and alternative index construction, while keeping costs low.

Most benchmark indices, such as the FTSE 100, use a market-cap weighted approach – as in, the 100 largest UK listed firm make up the index. But a smart beta fund focusing on the blue-chip index will use different filters, for example, it could track stocks based on the value of the dividends they pay.

While the long running argument between the two styles carries on, arguably the point is being missed. While passive investments should be at the top of the list for investors building a portfolio from scratch, both investment strategies have their place.

Nevertheless, all investments, whether actively or passively managed, can fall as well as rise in value and you may get back less than you invested.