A complete guide to passive investing

While actively managed funds still dominate the investment landscape, over the past few years, more and more investors have been turning to passive investing.

What is passive investing?

Passive investing is an increasingly popular investment strategy, where the investor tries to replicate an index (like the FTSE 100) and hold it for a long time. The strategy minimises buying and selling in order to save costs.

Okay, can you give me some more detail?

Passive funds have a number of different names including index funds, exchange traded funds (ETFs) or trackers. They will aim to replicate the performance of an index.

In the case of mainstream indices such as the FTSE 100 or S&P 500, the index simply tracks the share price of the largest shares listed in a specific region.

In the case of the FTSE 100, this is companies such as HSBC, BP or AstraZeneca – large global companies that draw their profits from across the globe. For the S&P 500, that will be the large technology names such as Amazon and Apple, alongside Johnson & Johnson and Exxon Mobil. The largest companies will have the largest weighting.

There are indices that look at criteria other than size – the Nasdaq, for example, focuses in on the leading technology companies, while the S&P 500 Dividend Aristocrats focuses on those companies paying the highest dividends. It is possible to find passive funds for these indices too.

Investors should always know what to expect with a passive fund. If the FTSE 100 rises 10%, so should their investment. Many investors like this simplicity.

A bit about ETFs

“ETFs” or exchange traded funds are a type of index fund. As the name suggests, they trade on an exchange so are bought and sold like normal shares.

They are usually super-cheap, even by the standards of passive investment, often only charging 0.1% for the most popular indices. Not all investment platforms offer ETFs, so investors need to make sure they’re with a platform that offers share trading.

Find out more about ETFs in our full guide.

Why should I care about passive investing?

They’re low cost and simple. Let’s look at both.

One big appeal of a passive fund is the low cost. An active fund will usually charge 65p–75p for every £100 you invest. A passive fund on one of the well-known indices may cost as little as 10–15p, with ETFs even cheaper.

This difference doesn’t sound a lot, but can really add up over time. Get ready, we’re going to do some maths.

At 5% growth, a £20,000 investment would grow to £69,625 over 25 years (assuming 5% growth). Shaving 0.5% off each year in costs would see this drop to £61,470.

Active managers will argue that their expertise can help people to greater returns than those available from an index. Importantly, it can also help protect capital in falling markets, when passive managers may be condemned to track the index lower.

In some cases, this is true, and certain active managers have delivered returns well in excess of the index and/or protected investor returns in falling markets. However, it is tough to pick the really skilled fund managers and some will go off the boil.

Another big draw when it comes to index funds is simplicity. They take some crucial elements out of the decision-making process.

However, you need to be aware that, for the most part, you’re getting a portfolio of the UK’s (or US’s or Europe’s) largest companies. If you’re looking to find the next Apple before anyone else, this isn’t the right option for you.

You will still have choices to make, such as which country, which sector and which index. It is worth remembering that you can always use passives for your core exposure, bringing in some racier elements round the sides – smaller companies or emerging markets, for example.

Passives have become very popular in recent years and it is easy to see why. They offer a cheap and easy way to get diversified market exposure, without the hassle of having to choose which fund manager is having a good moment.

Active vs passive investing

With active funds, a dedicated fund manager tries to pick the best stocks. Passive funds, in contrast, simply seek to replicate an index, such as the FTSE 100 or the S&P 500.

In theory, most people like the idea of a clever human picking the best shares for them. However, quite often, they turn out not to be much better than the index and, at times, considerably worse.

Equally, active funds cost more, which acts as a drag on your returns over time. With this in mind, many people have concluded that the most straightforward way to invest is via a passive fund.

Okay, so which should I pick – active or passive?

A lot of energy has been expended on the “active versus passive” debate: there are arguments on both sides. Certainly, if you get the right active manager, it can be a route to high returns, but finding them isn’t easy and you need to be sure you’re making the right choice. Equally, even the best fund managers will have rough patches and it’s not always easy to tell whether a rough patch is a permanent loss of form.

The best option is probably a bit of both. There are certain markets where it is very difficult to do better than the index. The S&P 500, for example, has proved difficult to beat and for the most part, investors have been better off investing in index products. There are sound reasons for this: the US market has a lot of active investors and this generally makes pricing more efficient.

However, in other areas, it is possible for active managers to add more value. In emerging markets, or smaller companies, there tends to be less-efficient pricing. Anomalies can persist. In these areas, it can be worth looking at an active fund, where an investment manager can really make a difference. Some active managers are great at what they do and will justify their extra fees in higher returns.