When it comes to saving money for the long term – that is, ten years or more – investing your money usually delivers better returns than simply saving it up as cash in the bank. This is why any workplace pension you have, for example, will at least partly be invested in the stock market, and most of the rest will be in bonds.
The majority of us don’t have the time, patience or enthusiasm necessary to do the research required to buy and sell individual shares for our own portfolios. This is why most people hand their money to a fund manager to do it for them – the fund manager gathers the money together and invests it in a portfolio of shares. This is known as “active management”. So far, so good.
When you invest money with an active fund manager, you want to know that they are using their skill to deliver you the best return they can. In the jargon, you want to know that they can deliver “alpha”.
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So if your fund manager is investing in big UK-listed stocks, for example, you would probably want to compare the returns the fund gives you with those of the main London index, the FTSE 100. You’d use the FTSE 100 as a “benchmark” – a figure that you’d expect the manager to beat over time.
This is where we hit a snag. Because the reality is that a majority of active fund managers struggle to beat their benchmarks – whatever they are – over any decent length of time. That’s partly because they also charge relatively high fees, which they have to earn back before you see any return yourself.
This is where passive investing comes in. Passive funds don’t try to beat a benchmark, they just try to track it. So a passive fund investing in UK stocks might just buy all the stocks in the FTSE 100 in the same proportion as the index.
Because this isn’t very labour-intensive and can be automated, the fees are lower too. So most of the time, an investor will get a better return, and pay less for the privilege, by opting for passive rather than active management.
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