In this series so far we’ve covered the concepts of risk and return, the role of shares and bonds in a portfolio and the relative merits of investing globally versus just locally.

Next on the agenda is so-called ‘active’ and ‘index’ investing. What exactly are they and why should I care as an investor?

Let’s start with index funds – also known as ‘passive’ funds or tracker funds. They are called index funds because they seek to produce a return that mimics the market return, as represented by an index such as the FTSE 100 or S&P 500.

To do that they will usually hold all or the majority of the company shares making up the index.

On paper they are very simple investment products, although behind the scenes they are anything but passive due to the complexities involved in constantly having to rebalance a fund’s holdings due to corporate actions, fund inflows and outflows, and changes in the underlying index.

Think of it as a swan gliding serenely above the water line but paddling frantically beneath it.

Active funds, on the other hand, deliberately deviate from the index in a bid to beat the market return. These rely more on the stock-picking skills of a fund manager who will research individual shares and bonds and invest in those they think will perform best.

They might also take positions at a sector level – for example, investing more in technology companies if they think that area of the market is going to do well or putting less in oil companies if they think the oil price is set for a big fall. In a global fund their stock choices might also reflect their views about particular countries or regions.

So which type of fund is best for you?

To answer that question the most sensible approach is to start by thinking about yourself. What do I want to achieve with my portfolio? What sort of return am I looking for? What’s the timeframe and how much risk can I stomach?

There are different risks involved when investing in index or active funds, so it’s important to consider what those risks might be before making up your mind.

Whichever route you go down (and you can invest in both index and active funds, if you wish), your portfolio will always be exposed to some level of market risk. The direction of the underlying market is always going to be a significant influence on the actual returns you see.

Now an index fund is trying to produce a return as close as possible to the market’s, so this market risk should explain close to 100% of your returns. But studies have also shown that market risk can explain more than 80% of the performance produced by active funds¹. So, if the market is up strongly, most active funds will follow suit; and if the market is down significantly, most active funds will produce losses.

Even so, active fund investors take on an additional level of risk called ‘manager risk’ because on any given day, some of the views reflected in the portfolio are likely to work and some are not. The fund manager will be hoping that, over time, more work out than don’t. But there’s no guarantee.

Taken together, that means that the spread of potential returns from an active fund is wider than it would be for a passive fund.

Cost is a killer

Active managers devote a lot of time and resources to researching potential investments for their portfolios. As a result, active fund costs tend to be higher than they are for index funds. And the higher the cost of the fund, the more outperformance your active manager will need to generate before they are putting any money in your pocket. As the chart below shows, most can often fail to clear this hurdle.

Share of underperforming active equity funds - before and after costs
(Monthly rolling 2-year average)

Past performance is not a reliable indicator of future results. Notes: Share of underperforming funds based on monthly rolling 2-year average. Active equity funds available for sale in the UK are considered. Net returns are calculated in GBP net of fees, gross of tax, with income reinvested. Gross returns are calculated in GBP gross of tax, with income reinvested. Time period observed: 02/2002 to 12/2020.  Source: Vanguard calculations, using data from Morningstar, Inc.

And even the most successful active managers experience periods – sometimes extended periods – of underperformance relative to the market.

You can’t control the direction of the market or the success of your chosen manager, but you can control costs. So, whether you choose to invest in an active or an index fund, choosing lower-cost funds will allow you to keep more of your returns.

The right blend of active and index will depend on your own personal circumstances and attitude to risk. At Vanguard, we believe that index funds are a sensible choice for the core of most investors’ portfolios, because of their simplicity, lower cost and narrower spread of potential returns.

 

¹ For example, Bender, Jennifer, P. Brett Hammond, and William Mok, 2014. Can Alpha Be Captured by Risk Premia? The Journal of Portfolio Management 40(2): 18–29.