While actively managed funds still dominate the investment landscape, over the past few years, more and more investors have been turning to passive investing. Find out what passive investing is, why you should care and how to invest passively.
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.
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.
“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.
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.
The simplest way to picture the difference is to think of an active approach as “hands-on” and a passive strategy as “hands-off”.
Both ways involve some input from you but active investing involves either you or a professional adjusting your course regularly, while passive means setting your course and mostly sticking to autopilot.
At its core, active investing attempts to beat the returns of the market, whereas passive investing usually attempts to match or mirror market performance. But success is never guaranteed with either option.
A helpful metaphor to consider is driving a car and navigating yourself (active) vs using a sat nav (passive) to reach a destination (ideally, wealth!).
Of course, it’s important to remember that when it comes to investing, you may not reach your desired destination at all. Whether you choose to invest actively or passively, you could end up with less money than the amount you put in.
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.
This is the main area that can set these strategies apart. Securities like passive broad-market exchange-traded funds (ETFs) can be much cheaper than actively managed funds.
The difference may only appear small in percentage terms, but it can significantly impact the overall value of your portfolio over time.
To give you an idea about costs, here’s what a typical range of charges can look like with an example of each strategy:
A TER is calculated by adding up the management fees, operating expenses, trading costs, and any additional costs of running an investment fund and then dividing this by the total value of the fund’s assets.
If you invested £10,000 in a fund with a 5% average return over 10 years, if the TER was 0.2% you’d pay a total of £307 in ongoing costs. If that TER was 1%, under the same scenario and conditions, you’d pay £1,487 in ongoing costs.
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.
This varies based on what you’re investing in. In most cases, passive investing is less risky, because you’re not attempting to outperform the market. Passive investment tends to mean less involvement, which can also reduce your odds of making a costly mistake.
Active investing relies on investing skill, which is needed to beat the market. But this also invites human error or poor judgement to play a role. You can lessen the risk involved with active investing by using professional advice or management – which comes with an added cost.
However, there’s always a certain level of risk you need to accept as an investor because there are never any guarantees that your chosen investments will perform or that you’ll make a profit – you can lose money with any strategy.
We currently don't have that product, but here are others to consider:
How we picked theseTo make comparing even easier we came up with the Finder Score. Costs, features, ease and range of investments across 30+ platforms are all weighted and scaled to produce a score out of 10. The higher the score the better the platform – simple.
Read the full methodologyActively managing your portfolio means using all the tools at your disposal to try to maximise your returns (or paying an expert to do this for you).
Examples of active investments include securities such as:
Active investing can be more time-consuming. This is because researching stocks and shares yourself, or researching funds and managers, can take effort. If you want to invest actively, choosing the right platform is vital.
Look for a platform that offers:
This way of investing best suits someone who:
This strategy is more of a slow-and-steady approach. Your aim is consistent growth rather than trying to outpace everyone, but there is still risk, of course.
The most common way of passive investing is to use low-cost, broad-market ETFs. Once you’ve chosen a fund (or multiple funds), you’d typically invest regularly, regardless of market conditions or stock performances.
By definition, you’ll never beat the market. However, lower fees mean you get to keep more of your returns. And some major stock markets’ long-term performance has still led to pretty significant growth (though of course that’s no guarantee).
Other common ways of investing passively can include putting money into assets such as:
This investing strategy best suits someone who:
If you decide passive investing is for you, using the right platform is also important. Ideally, you’ll want somewhere that offers cheap (or free) regular investing for shares or funds. You’ll also probably want a straightforward platform that’s easy to understand.
The whole point of passive investing is simplicity and lower costs. So, if you pick a complex platform or one with high fees, you’ll cancel out the best passive benefits.
This is all about finding out which method best suits your personality and investing goals, and how much risk you’re comfortable with. Remember, it’s also possible to create a portfolio with a blend of strategies.
For example, you may use passive investments as a foundation and then pick active investments like stocks or managed funds to give your portfolio some extra va-va-voom. You can always change how you like to invest later down the line. There’s no need to make a lifelong commitment and marry a strategy. Just make sure you’re investing actively or passively in a way you’re comfortable with, using an investment platform that best suits you.
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.
Want to know how to diversify your portfolio? Our guide explains healthy investment diversification, and shows you some example allocations. (Paid content)
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