We explain the key differences between active and passive investment, to help you find the best approach to meet your financial goals.
Once you decide to invest in stocks and shares, a key consideration is choosing between ‘active’ and ‘passive’ investing.
So, what exactly do we mean by this? In simple terms, active investing is when you ask an expert manager, through a collective fund structure or portfolio of funds, to selectively pick the stocks to meet your investment goals.
Passive investing is when your money is invested into one or a portfolio of funds, often exchange traded funds (ETFs), that mirror or ‘track’ the performance of an index.
Both active and passive investing have their pros and cons. Investors may also opt for a single strategy which incorporates elements of both styles, such as Nutmeg’s Smart Alpha portfolios, powered by J.P. Morgan Asset Management, which we’ll explore in more detail later.
Active vs passive investing: what are the key differences?
There is always plenty of debate about whether active investment or passive investment is the more successful approach. First, let’s first explain the differences between the two approaches.
What is active investment?
When you invest actively, the fund manager who oversees your money aims to outperform a stock market. They will have an index as their ‘benchmark’, which will detail companies of a certain size, expected growth and risk profile. The manager’s aim is to beat this benchmark.
So, if the fund you choose to invest in is UK equities, the benchmark that the manager wishes to beat might be the FTSE 100, the index of the UK’s largest listed stocks.
The manager, and in most cases their team, will aim to outperform that index by researching companies then buying shares in the ones they feel have the best prospects and avoiding the shares of those that do not.
They may buy and sell stocks frequently or seldom depending on their investment style and will usually work within a certain set of constraints – for example, only buying large or smaller listed stocks, or those in a certain sector, such as financials or technology – depending on the type of fund you have chosen.
What is passive investment?
With passive investment, the fund is set up so that it automatically tracks an index of equities or bonds, or the price of another asset; maybe a commodity such as gold or crude oil.
Going back to the UK equities example, if you were to invest into a FTSE 100 ETF, it will rise and fall very close to the same rate as the FTSE 100 index, as it is invested into every one of those 100 companies, usually weighted by the size of the different companies in the index.
This is a relatively simple example of the passive investment approach. Other investments are more complicated. For example, a multi-asset portfolio, such as those in the Nutmeg fully managed range, may contain a set or flexible proportion of different types of assets – for example, 20% may be invested in bonds and 80% in shares.
In this case, the setup is built to provide a complete portfolio to match a client’s particular attitude to risk – from an adventurous investor to someone who is more cautious. The building blocks of such portfolios are usually ETFs.
ETFs have the advantage in that they are in themselves listed so they can be bought on the stock exchange at any time of the day. Others are more traditional tracker funds, bought through a provider or fund supermarket.
The advantages of passive investing
- Because you do not have to pay the additional fees that a fund manager will charge, passive funds are usually a cheaper form of investment, which may have a positive impact on the return you get over time.
- Passive funds are usually very transparent and easy to understand, although some are more complex than others.
- Given their simplicity, an investor can have a good handle on what they own, rather than requiring updates from active managers who may implement more dynamic strategies.
The disadvantages of passive investing
- Passive funds will only ever track the benchmark rather than aim to beat it, so you may miss out on some growth opportunities.
- A passive fund may be inflexible and by its nature unable to react quickly to market changes, so if the market falls, your money falls with it.
- If the index or commodity your fund is tracking is particularly complex, there may be some tracking error, where your investment does not completely track the market, though this is likely to be minimal.
The advantages of active investing
- A good active manager may be able to beat the market over some timeframes, particularly if it is a niche area or a stock market not widely covered by analysts.
- An active manager and team should do research into the companies they buy and may have extra insight because they track the progress of management teams of those companies.
- An active manager can react quickly to change a portfolio in a situation such as a stock market crash.
The disadvantages of active investing
- Active investment is usually more expensive than passive investment because you must pay the fund manager.
- Frequent buying and selling of stocks can also affect returns because of the costs involved in doing this. It can also trigger higher Capital Gains Tax bills if you hold your investments outside a pension or ISA.
- Active managers are paid to outperform the benchmark and may take risks to do this that negatively affect returns.
Which is the right investment strategy for you?
The right investment strategy for you will depend on your circumstances, expertise and tolerance for risk. Nutmeg’s beginners guide may help to clarify this for you.
If you are concerned about the difference in performance between active and passive funds, it is worth looking at some historical figures.
Recent research from S&P Dow Jones, which provides an index showing how well fund managers do against benchmarks, suggests that only 45% of UK equity fund managers outperformed last year. That means; according to this research, most active funds performed worse than an equivalent tracker fund.
The same research found that only 15% of active managers investing in large or medium-sized companies outperformed the benchmark.
Those wanting to invest in both active and passive approaches, may consider the aforementioned Nutmeg Smart Alpha portfolios, powered by J.P. Morgan Asset Management. These combine Nutmeg’s core investment principles, and ETF selection expertise, with the in-house multi-asset knowledge and experience of one of the world’s leading investment houses.
Diversifying your investments
Whether you choose to invest through active or passive funds, or a mixture of the two, it’s important that the investments you hold within your portfolio are appropriately diversified.
Diversification simply means not having all your eggs in one basket. It means holding a good mixture of different types of shares and bonds, across different sectors and geographies. This can give you a smoother ride on your investment journey and help protect your money when stock markets fall.
Both active and passive funds can provide appropriate diversification, but many people find it easier to understand how their investments are spread in a passive fund.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicators of future performance. Tax treatment depends on your individual circumstances and may be subject to change in the future.