Active vs Passive Funds — Two Different Jobs

An active scheme is promising an attempt, not an outcome. A manager and a research team select companies within a mandate, with the aim of doing better than the stated benchmark, and our page on the fund manager describes what that job involves.

A passive scheme is promising something narrower and more reliable: to hold what the index holds and to stay close to it. Success is measured by how little it drifted, not by whether it did better, as our page on index funds explains.

So they are not competing on the same field. One is offering the possibility of more with the possibility of less. The other is offering the index minus a small cost, with very little variation around that.

Everything else in this debate is uncertain. This part is not.

An active scheme charges more because it employs people to make decisions. A passive scheme charges considerably less because it does not. That difference is deducted every year regardless of what markets do, and over long periods a recurring certain cost is a substantial thing, which our page on the expense ratio sets out.

The implication is straightforward. An active scheme has to do better than its benchmark by more than the extra cost before the investor is ahead. That is the bar, and it is a real bar rather than a rhetorical one.

The case for selection is not equally strong everywhere, and this is the part the loudest voices on both sides skip.

In the largest, most widely followed companies, information is abundant and the scope for a manager to know something others do not is limited. Among smaller and less followed companies, the differences between businesses are larger and less picked over, which is where selection has more to work with. Our page on large, mid and small cap funds covers those segments.

Debt is a different discussion again, because the risks a manager is managing there are credit and duration rather than company selection, as our page on debt funds sets out.

So the sensible version of this argument is segment by segment rather than a blanket verdict either way.

Worth stating, because the passive case is often presented as having no cost at all.

An index scheme holds everything in the index, including the parts a thoughtful person would avoid, and it holds them in whatever weights the index specifies. If the index is concentrated in a few sectors, so is your holding, whether or not that suits you.

It also has no ability to reduce exposure when something looks stretched. It does what the index does, which is the entire point and also a real limitation in specific conditions.

Access is worth a note too. Some passive exposures, particularly overseas ones, reach ordinary investors only through a fund of funds structure, which adds a layer of cost to what is otherwise the cheaper approach.

And the choice of index still matters. Two passive schemes tracking different indices are not the same investment, which our page on the benchmark covers.

The debate is usually presented as two options and there is a third arrangement sitting between them.

Some passive schemes do not track a plain market index. They track an index built on a rule: companies selected or weighted by a stated characteristic such as low volatility, quality measures or momentum, applied mechanically. There is no manager choosing, and there is also no attempt to hold the market as it is.

So it is passive in operation and active in intent, which is a genuine third thing rather than a marketing label. The cost usually sits between the two, and the rule can be out of favour for long stretches just as a manager style can.

What matters if you are considering one is that you are taking a position on the rule. That is a decision, not a default, and it deserves the same scrutiny as choosing a manager would.

If you hold one, the question is whether the attempt has been worth paying for, and that needs measuring properly.

Compare it against its own stated benchmark rather than a convenient one, over several years including a poor stretch, and using a consistent method rather than a favourable window. Our page on how returns are calculated covers why the window matters so much.

One caution: a scheme that closely resembles its index while charging active fees is the worst of both arrangements. That is checkable from the holdings on the fact sheet, and it is more common than the marketing suggests.

Most households hold both, and that is a sensible position rather than a failure to choose.

Passive holdings in the segments where selection has least room, active where it has more, and the split decided by how much you care about the possibility of doing better against the certainty of paying less. Neither answer is wrong and there is no verdict coming.

What we would push back on is treating this as the important decision. Whether you are invested at all, whether the horizon matches, whether the instalment is sustainable and whether you hold through a bad stretch decide far more than this choice does, as our page on asset allocation sets out.

We are distributors rather than investment advisers and we recommend no schemes on this site. If you want help reading what you already hold against the right reference, get in touch.