Active vs passive funds

Most investors get started by investing in funds. And one important choice that you need to make is between active and passive funds.

It’s really a choice between average performance, at a low cost, from a tracker fund, or the opportunity to do better than the average, for a higher fee, using an active fund. 

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The problem with active funds

With active funds there’s always the risk that they will underperform their benchmark stock market index, or similar funds. It happens a lot, because of factors like poor timing of purchases and sells, or too concentrated bets in particular industrial sectors or regions. 

Educational investment website FE Trustnet found between 22 January and 22 April 2025, the average active fund in most Investment Association fund sectors (which account for the vast majority of funds available to the public) has made a lower return than its passive counterpart. The research found active funds underperformed passive in 32 sectors in the Investment Association universe, while they outperformed in just 17.

Even the financial regulator has been worried about some active funds. 

In 2018, the Financial Conduct Authority reported on ‘closet trackers’ and ‘closet constrained funds’. These look like and charge fees similar to active funds. But they are managed in a way that is similar to passive funds which traditionally charge a much lower fee. 

The regulator said: “Closet constrained funds make active decisions. However, their investment strategy is constrained to making restricted decisions around their respective benchmarks. Closet trackers are passive, but look and charge like they are active.”

But if active funds do underperform, or perform the same as an equivalent tracker fund, they still usually take their management fee, which can undermine performance further.

A typical active fund will charge somewhere between 0.75% and 1% a year (known as the ongoing charges figure), which is higher than the majority of passive funds. Some index trackers now cost less than 0.10% a year.  

What are passive funds?

Passive funds are also known as tracker funds, because they track, or replicate, the performance of an established index of shares, such as the FTSE 100 or S&P 500. 

What are active funds?

Active funds have a professional manager who chooses how to invest the money in the fund. An active fund will aim to beat the performance of a benchmark stock market index, or a peer group, such as a fund sector – a group of funds that make similar investments and have similar objectives.

Are passive funds better?

There’s a large body of academic evidence supporting the argument for passive investing. For example, Morningstar’s research found only 23 per cent of active managers that focus on the US equity market outperformed their passive counterparts from 2010 to 2020.

In the UK, retail investment platforms reported that ISA season in 2023 — around March and April — was well and truly owned by tracker funds. They were bought much more than active funds. 

While, in October 2024, Interactive Investor, the investment platform, reported the rising dominance of passive funds, with 30 passive funds in the top 50 most popular funds held by its by customers versus 20 active funds. 

Some professional financial planners put their clients wholly into passives, arguing that they are better value and that getting average performance over the long term is less likely to disappoint than taking the risk of underperformance.

Can you get better than average?

Nevertheless, it’s human instinct to want to perform better than the average. Some find tracker funds very boring. While others believe the wisdom of crowds (aka passive) is a powerful force, that shouldn’t be an excuse to negate the individual desire to do better and to improve.

So the active vs passive debate still divides many investors and their advisers. And it is easy to find examples of funds that outperform. The longest-running actively managed fund in the UK is F&C Investment Trust, founded in 1868. Over the five years to 31 May, it outperformed its benchmark, delivering share price returns of 75.18% vs 71.59% from the FTSE All-World (Total Return) Index. The problem is picking active funds today as nobody can predict the future. Even F&C has had periods of underperformance.

One of the most important things to look for when picking an active fund is its performance track record. This isn’t a guarantee of good returns in future, but the longer the manager has been able to deliver outperformance, through stock market ups and downs, the more this is likely to be a result of skill, rather than luck.

Plus. some investors and advisers argue that an index is a sure guarantee that you won’t beat the stock market. In fact, you will always slightly underperform the average, once the fee is taken for management of the fund. They also point out that some indices are biased towards certain sectors, industries or geographies, or even certain company sizes, that might make them poor choices at certain times in the stock market cycle. Also, sometimes it’s just not possible to find a suitable index, particularly if it’s a niche area of the market. 

Some asset classes, such as private equity and commercial property, don’t work as tracker funds. That’s because the manager has to physically buy the shares in privately listed companies or own an office block or industrial warehouse. 

Mixing passive and active funds

An increasing number of DIY investors and professional advisers are choosing to mix the two approaches within portfolios. They might choose passive tracker funds where they are most suited, or where the index is difficult for active managers to beat, such as with US larger companies. Or they choose a very low-cost global tracker fund for the core of the portfolio, adding ‘satellites’ of active funds in small quantities around this. 

A core and satellite portfolio will keep the costs of investing down but also give the investor a chance to outperform the average.