What are active and passive funds?

Investors will debate the pros and cons of active versus passive funds and which are the best for their portfolios. Some believe it is better to invest in active funds unless they cannot find an active manager they are convinced can outperform the market.

Others choose to invest in passive funds unless they can find an active fund that can add value consistently.

To find out the rationales behind active and passive investment funds and how each type of fund can be combined to maximum effect, read: Blend active and passive funds for the right balance.

There is a strong argument for using both strategies, but for different parts of the same portfolio.

But how do active and passive funds differ and what can they offer to investors' portfolios?

Active funds

The basics

An active fund is one that has a fund manager at the helm selecting stocks, bonds or property that they believe will increase in value. The manager will bring their investment experience and market knowledge to bear and strive to deliver a return over and above that achieved by "the market".

The market in this context is usually a given benchmark: the FTSE All-Share for a UK investor, for example, or the S&P 500 for a US investor.

Characteristics

Active funds will be more expensive. The average open-ended equity fund focusing on a mainstream market index such as the FTSE All-Share or S&P 500 costs around 0.75% a year to manage. That said, costs are moving lower in response to increasing pricing pressure in the industry.

Active funds have a range of strategies that require analysis. Every fund manager has a style. They may prefer to invest in unloved "value" parts of the market - companies trading at low share prices historically and unpopular with investors. Alternatively, they may prioritise companies with high growth. Investors must try to identify the best managers of their type.

Active funds can perform very differently from the wider market. An active fund might rise as the FTSE 100 falls or vice versa, depending on the strategy of the manager and the stocks they buy.

The best active managers add a lot of value. Over the 12 months to 31 May the FTSE 100 was up 24%, according to FE Trustnet. The average gain in 268 funds in the UK all-companies sector was 31%. The top fund was up 62%. The weakest fund in this sector returned just 3.3%.

Passive funds

The basics

Passive funds aim to replicate the performance of an index, such as the FTSE All-Share or S&P 500 indices, but without striving to exceed the return from that index.

The way individual passive funds track those indices varies considerably. Some are structured as open-ended funds (Oeics or unit trusts) - these are marked in Money Observer's AnalyseMoney section with a red dot. Others are structured as exchange traded funds (ETFs) listed on the London Stock Exchange (and others).

It should be noted that an increasing number of funds employ strategies that defy easy categorisation as active or passive, such as quasi-passive active funds and quasi-active passive funds. Confused? Quasi-passive active funds are low-turnover, low-cost funds, possibly run using a quantitative methodology. Quasiactive passive funds are ETFs that enhance an index by, say, screening all stocks for those paying a dividend and only investing in those.

Characteristics

Passive is cheaper. Passive funds are, on the whole, cheaper than active funds. There are no overheads for a well-paid fund manager, and often fewer trading costs. The annual costs for an exchange traded fund tracking the FTSE 100 index can be as low as 0.15%.

Passive funds are readily tradeable. Passive funds are often large and liquid, so investors can move in and out quickly. This is particularly the case with exchange traded funds, making passive funds a simpler way to take short-term directional bets on markets. An active fund will have a manager's skew and may not provide straightforward market exposure.

Passive fund performance depends on the benchmark. If a passive fund is based on a market capitalisation-weighted benchmark, such as the FTSE All-Share, larger stocks will be over-represented. If it is based on a dividend-weighted index, it will perform well when high-yielding stocks have a strong run.

Passive strategies can track esoteric asset classes such as commodities or volatility. For direct access to, say, the gold or oil price, a passive strategy - usually through an ETF or exchange traded commodity - is often the cheapest and simplest option. Frequently, the prices of quoted gold or oil company shares correlate with the prices of the underlying commodity, but the share price will also be aff ected by other factors, such as corporate management skill and balance sheet strength.

Passive funds may be less diversified. The FTSE 100, for example, is heavily weighted to the oil and gas, healthcare and banking sectors. A passive investor will hold relatively little in areas such as technology, retail or homebuilding.

Passive will not protect capital in a market downturn. Because there is no "intelligent oversight", passive funds will simply track the market lower as it falls, rather than, say, put money into cash or more defensive areas as a fund manager might.