If you’re looking to grow your money by investing in the stock market via a fund, there are two main investment strategies to choose from. Deciding between active or passive investments can have a significant impact on your money, so it’s worth weighing up the pros and cons of each.
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Active or passive investments – what’s the difference?
The involves entrusting your money to a fund manager who draws on their expertise to buy a range of assets that suit your investment goals. They actively monitor your investment, making decisions on when to buy and sell assets on a daily basis. Their aim is to exceed market performance when markets rise and fall.
This aims to produce a return as close as possible to a given market index.
Known as index funds or tracker funds, passive investment funds track a market index such as the FTSE 100. The value of the passive fund will rise and fall in line with the movement of the index. Passive funds offer no opportunity to outperform the index when the market is rising, nor can they protect your investments from falling in value when the market falls.
Understanding the difference between active or passive investments is the first step to growing your money to achieve your financial goals.
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What are passive funds?
A passive fund is designed to track an index – a selection of assets that represents a particular market. The FTSE 100, for example, is an index that represents the stock performance of the UK’s 100 largest companies.
A passive investment strategy can be applied to various funds including equity mutual funds and exchange traded funds (ETFs). What they have in common is that they hold shares in all the assets that make up the index.
The number of shares bought in each asset correlates to the market value of each company in the index. This allows the portfolio to accurately match the movements of the index as a whole.
Passive funds have no fund manager and no research is completed beyond ensuring that the fund reflects the index.
When the index rises, the value of the passive fund rises with it. If the market takes a turn for the worse, the value of your investment falls in line with the index. Passive funds offer no ability to outperform the market. They will always marginally underperform their index once management costs are factored in.
Benefits of passive funds
Simplicity – Many investors feel more comfortable with passive funds because they follow a simple premise: track an index. You always know how your fund is performing. They are, however, subject to total market risk.
Lower cost – With less day-to-day management and fewer stock transactions, passive funds are usually cheaper than actively managed funds. Many tracker funds charge annual fees ranging from 0.15% to 0.2%. This compares to a typical yearly charge for an actively managed fund of 0.35% – 1.25%.
Drawbacks of passive funds
Less agile – As a passive fund simply tracks an index, it follows both the ups and the downs of the index. If markets fall, there’s no opportunity to switch to safer investments or increase exposure to lower-priced assets.
Lack of diversification – Passive funds may concentrate investments in the most popular stocks. In some cases, an index may be over-exposed to one or a small number of stocks or sectors that can have a large impact on performance.
Tracking errors – No passive fund accurately matches an index and tracking errors show the difference between the two as a percentage. A fund with a low tracking error means it’s closely following its index whereas a higher tracking error indicates the opposite. Over time, a fund with a higher tracking error may have a significant impact on your returns.
What is an actively managed fund?
Active investment funds are run by a fund manager supported by a team of researchers and analysts. Managers invest your money in a range of assets best suited to achieving your financial goals. They monitor your investment and proactively buy and sell assets on a daily basis to ensure the best possible return.
The aim of an actively managed fund is to deliver a return that is superior to the market as a whole and to protect the value of your investments should markets fall.
Benefits of an actively managed fund
Potential for higher returns – While not all active funds outperform the market, if you’re looking for the potential to grow your money at a rate faster than that offered by an index tracker, an actively managed investment portfolio is worth considering.
Risk management – Fund managers can tailor an investment strategy to suit your financial goals and attitude to risk. With the ability to invest in a range of assets, actively managed funds can hold a far more diverse portfolio than index trackers. Holding a broader spread of asset classes can reduce the overall risk to your portfolio as more will be invested in low risk assets such as cash and bonds. Higher risk portfolios typically hold a greater exposure to equities.
Active management – Steering investments tactically when markets are overvalued or falling is a key part of active management. This means investing in different sectors and taking advantage of specific sector growth or moving money into safer havens when markets are turbulent.
Drawbacks of actively managed funds
Performance – Fund performance is linked to the skill and experience of the fund manager. If they make the wrong call, you may get a below-market performance.
Costs – Actively managed funds typically have higher management fees than passive funds. Nonetheless, many investors are happy to pay slightly more in fees in exchange for potentially higher returns.
Active or passive investing – which should you choose?
A passive investment strategy is based on the belief that active managers are unlikely to beat the markets over the long term and therefore the wisest choice for investors is to simply track the market. Proponents of active investing argue that it is the skill of active managers in steering investments in the face of changing markets that makes active funds the better option.
Much of the debate focuses on whether it’s worth paying the higher management costs of an active fund or whether you’re likely to enjoy greater returns in the long run by opting for cheaper passive investments.
It’s important to remember that neither strategy guarantees success, and both passive and active investments may have a place in most people’s investment plans depending on your attitude to risk.
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All investment carries risk and you may get back less than you invested. The information contained in this article does not constitute advice and the information referred to may not be the same for all. You should always seek professional guidance from your independent financial advisor before taking any action.