Active investing vs passive investing: which is best?
Active investing strategies didn’t do well in 2023 as passive investing continued to draw in new assets.
Investing in its most simple sense is the process of laying out money today with the hopes of receiving more money back in the future. And there are really two ways of accomplishing this aim, active investing and passive investing.
Active investing, as its name suggests, involves being active with your investments. That means picking stocks, bonds and other assets to go in your portfolio based on your analysis of the underlying investment. Active funds use the same investment approach.
Passive investing is all about letting the market do the hard work for you. Rather than trying to pick stocks and outperform the market, passive investing involves buying the whole market through a passive tracker or index fund.
There is a bit of a crossover here, as some investors may prefer to buy a selection of passive funds to build exposure to different markets. This is a form of active investing, but for the sake of simplicity, in this article, we’re going to look at the difference between active investing funds and passive investing funds, and discuss whether one strategy is better than the other.
What is an active fund?
As the name suggests, active investing requires active decision-making.
An active fund will employ a portfolio manager to hand-pick stocks (or other assets) to buy and sell when they think it’s the right time based on how they’re performing.
A smaller basket of stocks might seem more protected from wider market turmoil, but timing and beating the market is hard and active managers aren’t guaranteed to succeed.
According to data from Morningstar, over the ten-year period to June 2022, only one in four active funds outperformed their passive peers.
And the latest research from Hargreaves Lansdown shows the proportion of active managers that outperformed passive funds was lower than usual in 2022.
“This shouldn’t be a surprise: one year is a short time period, giving active managers limited scope to outperform – most have targets based on at least three to five years’ worth of performance,” says Hal Cook, senior investment analyst at Hargreaves Lansdown.
Given the hefty costs active funds charge, this lack of performance is a problem. If you’re paying an active manager, you’d expect them to deliver. As the data shows, this isn’t always the case.
Actively managed funds charge a fee of between 0.75% and 1.25%, according to Which?, that eats into your returns.
That said, some active managers are able to deliver consistent returns and have quite a good record.
Morningstar is useful for looking at a fund’s performance. It’s a good idea to regularly review the active funds you own to see if they’re still worth the fees or if you should look into passive funds instead.
What is passive investing?
Passive funds, such as index funds or tracker funds, aim to deliver the same returns as the market. An index fund will copy the composition of an index, such as the FTSE 100, and if you buy into it you’re effectively investing in all the companies that make up the index.
This allows you access to a diverse range of companies. The main downside is that there is no chance of outperforming.
When you invest in a passive fund, you should look for a low tracking error – that’s the difference between the fund’s performance and its underlying index’s performance.
The stocks in a passive fund shouldn’t change much – only when the constituents of the underlying index change. So if returns significantly differ from the index, it means the fund might not follow a passive strategy after all, or you’re paying extra fees.
Passively managed funds also carry far lower fees than actively managed funds do, which adds to their appeal. According to Which? they range from as little as 0.1% to 0.85%.
Which are better: active funds or passive funds?
“This is all a bit damning for active funds: they seem to struggle to outperform with any sort of consistency and are becoming less popular over time,” says Cook. “So, shouldn’t we all just switch? I’m going to continue to answer that with a no. There are a couple of reasons why.”
“Firstly, the performance data here is averages: while the average manager didn’t outperform, there are some that did,” Cook continues. “And there are some that do manage to outperform consistently over time.
“Secondly, this data just tells you if something outperformed or underperformed the passive. It doesn’t tell you by how much. One year of large outperformance and four years of small underperformance can still result in outperformance over the long-term.”
Third, there’s a big difference between the performance of US active funds and those focused on the UK market.
Active UK funds outperform US funds
“Historically UK equity managers have shown a better ability to outperform passive equivalents than managers in most other regions,” says Cook.
“This was not true in 2022, with the Oil & Gas sector adding notable performance to the FTSE All Share, and in turn, passive funds, and small and mid-sized companies underperforming their larger counterparts.”
Oil and gas companies posted record profits in 2022 thanks to the rising cost of energy following the war in Ukraine.
UK active managers have also decreased their exposure to the oil and gas sector in recent years due to the “rise of responsible investing,” hurting their performance last year.
In the UK only 26 out of 188 active funds outperformed Vanguard’s FTSE UK All Share Index tracker. That’s a significant decrease from last year’s figure of 69.
On the other side of the pond, US equity managers outperformed in 2022 compared to their historic average.
Still, this performance is unlikely to last. “It’s notoriously difficult to outperform passive funds in the US consistently over time, in part due to the number of people analysing companies there along with the sheer volume of information available,” says Cook.
Most of the US market’s losses came from the technology sector. Many tech stocks suffered huge losses last year after experiencing a pandemic-induced boom. In light of their heightened valuations some active managers were expecting a correction, so decreased their holdings in tech stocks ahead of the crash. That helped their performance.
In the US, 38 out of 105 active funds outperformed Vanguard’s US 500 Stock Index, which tracks the S&P 500. That’s an increase from just 19 last year. “Long-term though, most active managers underperform passive funds in the [US],” says Cook.
Meanwhile, passive funds increased in popularity, continuing to take market share.
“In 2010 about 10% of assets invested in mutual funds were passive in nature, this has increased to around 25% by the end of 2022,” says Cook. “Despite falling markets in 2022, passive funds continued to see net inflows, while active funds saw net outflows.”
Passive funds’ low fees coupled with the fact active managers rarely manage to outperform the market over the long term, suggests they’re the better buy on the whole.
But, if you want access to a specific sector instead of the very wide range of companies that make up an index, you might want to look into active funds with a good record.
• With additional contributions from Rupert Hargreaves