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Active vs passive funds: which suit you best?

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Discover the difference between active and passive funds...

When it comes to investing in funds, there's no shortage of options. To simplify the choice (a little bit, at least), you might want to first consider whether to invest in active or passive funds. 

Let's take a look at how each works, and the pros and cons involved, to help you decide which one - or which combination - might be right for you.

What are funds?

Investment funds are ready-made baskets of investments. You can invest money in a fund alongside lots of other people. That pool of money is used to buy assets, for example shares in different companies. 

Many people invest in funds because they give you access to lots of underlying investments in one go and are lower risk than buying shares in individual companies.

What is active investing?

Investing in actively managed funds is where a fund manager or a management team makes decisions about how to invest the fund's money.

The job of an active fund manager is to choose which investments to hold within the fund. They aim to outperform their fund's stated benchmark or index - such as the FTSE 100 - over time. For example, if the FTSE 100 goes up by 5% over 12 months, the fund would aim to provide returns of above 5%.

Together with a team of analysts and researchers, the manager will actively buy and sell stocks to try to achieve this goal.

If you're considering active funds, look at a manager's long-term track record across a variety of market conditions - good times and bad. But as always, keep in mind that past performance isn't necessarily a reliable indicator of future performance. 

What is passive investing?

Passive investing means investing in funds that aim to match the returns of a specific market or index. They don't try to beat it. They simply replicate the movement of the market they're tracking.

For example, a fund tracking the FTSE 100 will buy shares in all 100 companies and in the same proportions as their market value. This means the value of the fund will move in line with the change in the value of the FTSE 100 Index.

Exchange Traded Funds (ETFs) are an example of passive funds. They're listed on stock exchanges and can be bought and sold like shares.

Which investment method should you pick?

To help you decide which is more suitable for you, here are some the pros and cons of each investing style.

Active funds

Pros

  • they make it possible to beat the market index

  • fund managers build diversified portfolios to manage the balance between risk and potential reward for investors

  • they may be able to spot opportunities or react to market downturns by selling poor performing investments, for example

Cons

  • there's no guarantee an active fund will perform better than the index - in fact, research shows that relatively few active funds do

  • it's not enough to just beat the index - active funds have to beat it by at least enough to cover their expenses, such as transaction fees

  • they tend to have higher costs which can impact long-term returns

Passive funds

Pros

  • passive funds can be an easy way to diversify within asset classes and markets

  • with no managers to pay, they generally have very low fees

  • as management charges eat into investment returns over time, the advantage of low fees cannot be overstated

Cons

  • your return depends entirely on the performance of the index being tracked, so if the market falls, so will the value of your investment

  • you may be overly exposed to one asset class or market

  • there's no flexibility to avoid overvalued sectors or stocks, for example, in the financial crisis of 2008, when the FTSE 100 had a large weighting in banking stocks

Key takeaways

If you don't have time to research active funds, or feel comfortable choosing between them, passive funds may be a better choice. They're a low-cost way to invest in individual sectors or regions without having to select active funds or individual stocks. 

But it doesn't have to be an either-or choice. It's possible to build diversified portfolios by combining active and passive funds. If you choose to invest in a portfolio of investment funds they will normally combine both active and passive funds.

With active funds, keep in mind that some have lower fees and a better track record than others. And remember: a great performance over a year or two is no guarantee that the fund will continue to outperform. Instead you may want to look for fund managers who have consistently outperformed over long periods. 

As always, think about your own financial situation, your goals, and the amount of risk you're comfortable taking before you invest your money. If you're new to investing you may wish to talk to an adviser before making any investment decisions.

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Disclaimer

Please remember that the value of investments, and any income received from them, can fall as well as rise, is not guaranteed and you may not get back the amount you invested. This could also happen as a result of changes in currency exchange rates, particularly where overseas securities are held or where investments are converted from one currency to another. We always recommend that any Investments held should be viewed as a medium to long-term investment, at least five years.

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This article is not investment advice or a recommendation nor is it intended to sell investments or services or solicit purchases or subscriptions for them. This article does not constitute an invitation, or a solicitation, to make an investment in any way to any person to whom it is unlawful. This article should not be used as the basis for any decision on taxation, estate, trusts or legacy planning. You should not use or rely on this article in making any investment decision. HSBC Bank plc, Jersey Branch, Guernsey branch, Isle of Man branch and the HSBC Group are not responsible for such use or reliance by you.

HSBC Bank plc, Jersey Branch has prepared this article based on publicly available information at the time of preparation from sources it believes to be reliable but it has not independently verified such information. Any opinions expressed are given in good faith but no liability is accepted for any direct or consequential loss arising from the use of this information. The opinion quoted is for information only and does not constitute investment advice or a recommendation to any reader to buy or sell investments. 

Any market information shown refers to the past and should not be seen as an indication of future market performance.

You should consult your professional advisor in your jurisdiction if you have any questions regarding the contents of this article.

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