Active vs Passive Investment Choosing the Right Investment Strategy

Whichever option you choose, or whether you decide to invest in both active and passive funds, you must accept that your investments can still fall in value as well as rise and you might get back less than you invest. However, active funds are usually less transparent, with active managers often reluctant to disclose their holdings on the basis that their investment ideas could then be used by competitors. Both active and passive funds can provide appropriate diversification, but many people find it easier to understand how their investments are spread in a passive fund. This is why passive funds or tracker funds, as we sometimes call them, have got really popular because they are cheap. You can invest in a passive fund that follows the FTSE for about 0.06% a year, which is tiny. Active funds got a few wages to pay over here, so quite a bit more expensive, on average, 0.75%.

How managers decide to populate their portfolios and the emphasis they place on each of the areas mentioned above will define their investment approach. Irrespective of the exact investment process, managers will likely either follow a passive, active or combined approach to investing. Aims to capture the return of the market with a buy-and-hold strategy via index trackers and rules-based funds. The crux of the debate centres around whether active funds have justified their higher fees by outperforming their passive counterparts.

Finding the right strategy for the right market

The simple answer is that there’s a place for both types of investment as part of a balanced portfolio. First, we provide paid placements to advertisers to present their offers. The payments we receive for those placements affects how and where advertisers’ offers appear on the site. https://xcritical.com/ This site does not include all companies or products available within the market. To help support our reporting work, and to continue our ability to provide this content for free to our readers, we receive payment from the companies that advertise on the Forbes Advisor site.

• Passive investment involves investors’ money being used to buy a “basket” of investments in line with a particular index; the weighting of each holding is automatically adjusted to follow the index over time.
• Unlike active investing, passive investing doesn’t try to beat the market; its objective is the market return.
• Please remember, investment value can go up or down and you could get back less than you invest.
• If exceptional managers cannot be identified and the exposure to the underlying asset is still desirable, then passive funds should be used to implement the decision.
• ETFs have the advantage in that they are in themselves listed so they can be bought on the stock exchange at any time of the day.
• Specifically, within fixed income, a market-weighted index might not make the most sense (ie the most indebted countries/companies have a higher weighting) from a risk and return perspective.

Tax rules may change and the value of tax reliefs depends on your individual circumstances. The focus thus far has been purely performance-related, and specifically within equities. The argument changes slightly when you take into account investors with other goals rather than just maximum return. Typically to reduce risk, you increase the diversification of a portfolio by increasing weightings to lower-risk investments, such as cash, fixed income, or alternatives at the expense of equities. Within these markets, passive investing is a separate subject, as the availability of indices varies. Specifically, within fixed income, a market-weighted index might not make the most sense (ie the most indebted countries/companies have a higher weighting) from a risk and return perspective.

What’s the difference between active and passive investment?

Generally, very few adjustments are made to the portfolio’s allocations with the aim being to track the benchmark index as efficiently and cheaply as possible. Tactical asset allocations – shorter-term adjustments to portfolio allocations to either take advantage of a perceived return opportunity or protect against a potential risk. It’s also worth comparing the best trading platforms for your portfolio as the range of investments and fees can vary significantly. Faced with this existential threat, the active fund management industry has naturally come out fighting in defence of the stock picker.

This is where a financial adviser can add value as they will be able to develop an investment plan that is tailored to your individual requirements. Investments in stocks and Exchange Traded Funds (“ETFs”) may decline in value, potentially meaning that you may get back less than you invested. By using this website, you accept our Terms of Use and Private Policy. Where R represents the rate of return on the portfolio, Rf is the rate of return that is risk free, Beta reflects the systematic risk of the portfolio, Rm is the overall return on the market and Alpha reflects the risk free return. The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek professional independent advice.

Have active funds outperformed passives?

When comparing most active fund managers, it is important to view them relative to a benchmark. This allows you to analyse whether you would have been better off buying a passive fund with the same active trading vs passive investing exposure, or whether the manager has had quantifiable skill over the same period. The areas in which active managers have traditionally outperformed is within the small capitalization stock market.

The specialist knowledge and experience of a fund manager could potentially produce greater returns by tracking down the best assets, although there are no guarantees. Other examples of more specialised areas of investment that may possibly benefit from an active approach include healthcare, technology and smaller companies. Clearly it isn’t always possible to pick the best-performing fund, but active funds have the potential to deliver far higher returns to investors. That said, not all active funds justify their higher management fee in terms of outperforming passive funds, particularly in certain sectors. The UK has been a happier hunting ground for active fund managers, with 85% of active funds outperforming. Many of these funds invest in small and mid-cap companies, where there’s more opportunity for stock-picking and the potential for higher returns.

Active Investing Advantages

If you don’t have time or inclination to research and monitor active fund managers, passive funds providing broad exposure to different regions may be a better option. The evidence is overwhelming that active funds generally struggle to outperform their benchmark after fees over time. While there are managers that will outperform, we know it is very difficult to consistently identify them before they do. As a result, we focus on investing through passive funds and ETFs, a process we describe in detail here.