Active and passive investing: what’s the difference?

Rising inflation and market volatility have reignited the long-running debate over the most effective way to deliver investment returns. In this month’s article, we look at active and passive investing – what do these strategies entail and how can they benefit your portfolio in current markets? 

Global stock markets have been impacted by the effects of Russia’s invasion of Ukraine, which has contributed to rising inflation and greater geopolitical uncertainty. The US Dow Jones index fell 15% in the first six months of 2022, while the (tech-heavy) Nasdaq Composite index was down 29.2% by 30 June and the S&P 500 by around 20%.1

While the UK’s FTSE 100 index has endured some ups and downs so far in 2022, it has held up well by comparison. But with an uncertain outlook and the Bank of England forecasting a period of recession in the UK2 , investors are understandably concerned about the potential impact on their portfolios.

Investment funds fall broadly under two umbrellas – active or passive. This refers to their investment approach and philosophy, which can have an impact on how they might perform in different market environments.

So, what are they?

Hands-off

Passive funds are designed to follow or replicate a specific index or market, without seeking to outperform it. Although this type of fund will be built by a fund manager, the aim is to reflect the index (or indices) that it’s linked to rather than make ongoing decisions about what to invest in or not invest in. The value of this type of fund should simply go up and down in line with the chosen market or index.

One consequence of this is that activity levels tend to be lower, which helps keep charges down and ensures more of the gains end up in investors’ pockets.

On the downside, however, their relative lack of flexibility means there’s not much that managers can do to protect investors when the index or indices with which they’re linked falls in value. 

It’s worth remembering too that investors will only get the returns that the relevant index or indices produce, minus the fund fees they’re charged. Similarly, passive funds can be exposed to ‘concentration risk’, where they are dragged down by the underperformance of a particular stock or sector that happens to account for a big chunk of the market capitalisation in the linked index. However, some passive funds are structured in a way that mitigates this by using different weighting strategies.

Keeping active

Active funds on the other hand are where the fund manager is actively involved in making decisions over the specific investments (within the overall agreed strategy of the fund), with the overall aim of outperforming a certain index or peer group. For instance, they can choose which companies, countries and industries to invest in (within certain parameters) and make those decisions based on their knowledge, experience and the research resources at their disposal.

The main advantage of this approach is that the greater flexibility and freedom afforded to the fund manager means active funds have a chance of delivering returns for investors that are better than the performance of the stock market. It also gives them the ability to act in response to certain events, such as market movements, political developments and economic turbulence.

At the same time, however, those investment decisions won’t always come off and there’s a risk of underperforming the market. An actively managed fund can behave unpredictably during times of market turbulence, especially if its underlying investments diverge significantly from its benchmark index. The returns received by investors can also be reduced by charges, which tend to be higher on active funds due to factors such as the level of trading activity.

No either/or

The respective merits of active and passive funds mean that often they will be most effective when used together. Due to their differences, they can combine well in the same portfolio by playing complementary roles.

For instance, for some clients it can be beneficial to use low-cost passive funds that provide exposure to the main global indices, with active funds employed alongside them to exploit particular growth opportunities or for a regular income. This is sometimes referred to as a core/satellite strategy.

For other clients, a reverse of this approach might be more suitable, where active funds form the basis of the portfolio and passive funds are used to secure low-cost access to specific markets, such as selected commodities, industries or regions. Passive funds can also be used where actively managed funds can struggle to outperform the main indices, such as North America, where companies are so deeply researched that it can be difficult for active managers to identify potential opportunities.

Each approach has its pros and cons, particularly around performance and cost. The most effective blend will depend on your objectives, circumstances and attitude to risk, among other factors and your financial adviser will ensure that your portfolio is positioned to take best advantage of the strategies available to fit your risk appetite to meet your financial goals.

Next steps

Volatile markets can cause concern even for seasoned investors. If you are worried about your investments in the current markets or have any questions about how your portfolio is positioned, we’re here to help, so please get in touch.

1FTSE 100 stocks: winners and losers so far in 2022 | The Motley Fool UK

2UK will fall into recession this year, warns Bank – BBC News