Why you should always look for a passive fund first

John Stepek explains why you should always go for a passive fund over an active one, and outlines the two main types to choose from.

There's a story you often see in the money pages of the Sunday supplements at times when the market is flat or falling. It's one that never fails to amuse me. It goes like this: a pundit – usually someone whose job it is to sell funds – will grudgingly admit that most active fund managers fail to beat the market consistently. He'll accept that, in a rising market, there's a case for buying a passive fund, one that merely tracks the market higher. But then he'll add sagely: "Ah, but in a bear market like this, you want an active manager on your side." This'll be justified with some guff about how an active manager can use their "skill-set" to be more "agile", reacting nimbly to "ever-changing market conditions" like some sort of investment gazelle.

Read this nonsense in a Sunday morning haze, before your first cup of coffee, and you might think it makes sense. After all, if the market is going down, why would you want to track the market? You'll only lose money. So why not put your money with an active manager? At least they've got a chance of making you some money. That's got to be better than a guaranteed loss, hasn't it?

There are two reasons why this is complete rubbish. The first, minor reason is that most studies show that active managers fail to beat the market during bear markets as well as bull markets. So when markets fall, actively managed funds generally fall further and harder. So much for agility. But the most important reason is that the whole argument only makes any sense if there's only one place where you can put your money. And there isn't.

There are only two things you can control when investing

There are only two things you have any real control over when you decide to invest in something. One is the price you pay. Obviously you can't dictate your price: if BP shares are trading at £4 a pop, no one will sell them to you for £2. But you can decide on a price that you're willing to pay for an asset. You can then stick to it until either the market decides to offer it to you for that price, or you find a better option. In other words, no one is forcing you to buy something if you think it's expensive. 

So if you think the FTSE 100 is locked in a long-term bear market and that it's going to keep falling, then the answer is simple: don't use a passive or an active fund to buy it; don't invest in it at all. Ignore it, unless and until it falls to a level at which you want to buy. Instead, put your money in a different market. From China to Brazil to Japan to the US and everywhere in between there are plenty of places to put your money. And if you think stocks in general are doomed, then how about bonds? Or commodities? And there's always cash. Even a 0% return is better than a negative one. So there's never any need to invest with a mediocre “active” manager. There's always a better option out there.

The second thing you can control is your cost of investment. Investing always incurs some level of transaction costs. As we noted last time, the lower your costs, the bigger your returns. In short, regardless of what strategy you are following, your investment process will have two basic stages. You find an asset that you want to invest in; and then you find the cheapest way to invest in it. And the one thing you can say for sure about passive funds is that they are cheaper than active funds. Sure, they aren't always the best way to gain access to a given market. But they should be one of your first ports of call.

There are two main types of passive fund. One, usually known as a tracker fund, is similar to a unit trust, in that it is not listed. Instead you buy them through a fund platform. The other type is the exchange-traded fund (ETF). ETFs are listed on the stock exchange just like any other share. You buy and sell them (incurring the usual transaction fees, such as dealing costs) like a stock too.

Recommended

Persimmon yields 12.3%, but can you trust the company to deliver?
Share tips

Persimmon yields 12.3%, but can you trust the company to deliver?

With a dividend yield of 12.3%, Persimmon looks like a highly attractive prospect for income investors. But that sort of yield can also indicate compa…
1 Jul 2022
The MoneyWeek Podcast: nuggets of positivity in an extended bear market
Investment strategy

The MoneyWeek Podcast: nuggets of positivity in an extended bear market

Merryn and John talk about he need for higher wages and lower house prices, and why the fact that this is the least dramatic bear market they’ve ever …
1 Jul 2022
Here are the best savings accounts on the market now
Savings

Here are the best savings accounts on the market now

With inflation at more than 9%, your savings are not going to keep pace with the rising cost of living. But you can at least slow the rate at which yo…
1 Jul 2022
Don’t try to time the bottom – start buying good companies now
Investment strategy

Don’t try to time the bottom – start buying good companies now

Markets are having a rough time, so you may be tempted to wait to try to call the bottom and pick up some bargains. But that would be a mistake, says …
1 Jul 2022

Most Popular

UK house prices are definitely cooling off – but are they heading for a fall?
House prices

UK house prices are definitely cooling off – but are they heading for a fall?

UK house prices hit a fresh high in June, but as interest rates start to rise, the market is cooling John Stepek assesses just how much of an effect h…
30 Jun 2022
The ten highest dividend yields in the FTSE 100
Income investing

The ten highest dividend yields in the FTSE 100

Rupert Hargreaves looks at the FTSE 100’s top yielding stocks for income investors to consider.
22 Jun 2022
Gold has been incredibly boring to own – but that’s no bad thing right now
Gold

Gold has been incredibly boring to own – but that’s no bad thing right now

Stocks, bonds and cryptocurrencies have all seen big falls this year. But gold remains at its one-year average. It may be dull, but it’s doing what it…
29 Jun 2022