The benefits and risks of passive investing | Barclays Smart Investor (2024)

Actively managed funds still dominate the world of investing but the popularity of passive investments is rising fast. Latest figures from The Investment Association show that the amount of money invested in computer-run index trackers in the UK amounts to more than £150bn. We look at what you need to know about passive investments.

What are passive funds?

Passive funds track the performance of a particular market or index, such as the FTSE 100. As well as unit trusts or open-ended investment companies (OEICs), passive funds can also be stock market listed exchange traded funds (ETFs). What they all have in common is that they typically hold all the assets in the index they’re tracking, or a representative sample.

Crucially, most passive funds are operated automatically rather than by a fund manager, which dramatically reduces their running costs.

Much of the debate between active and passive strategies comes down to this issue. Essentially, whether it’s worth paying the higher costs levied by active fund managers or whether you’re more likely to enjoy greater rewards in the long run by sticking to cheaper passive vehicles.

One of our principles of investing is that you should only move away from passive investments if you have good reason and fully understand the total cost incurred.

What’s the difference in terms of costs?

In many cases, investors pay annual charges of around 0.75% a year for actively managed funds. In contrast, some passive funds charge less than 0.1% a year.

The difference between the figures may appear small but over time their impact on your returns can be considerable. Take the following example, bearing in mind that these figures are based on a simplified example and are for illustrative purposes only – consistent returns over a prolonged period are very unlikely.

Let’s say you invested a £10,000 lump sum into a passive fund paying a total of 0.1% a year. Assuming you enjoy 4% growth every year, your initial investment would be worth £21,493 after 20 years.

However, the same amount invested in an actively managed fund with a 0.75% annual charge would grow to just £18,959 over the same period once fees have been deducted. That’s a difference of almost £3,000 just as a result of the fee.1

Active versus passive funds

Critics of passive investing say funds that simply track an index will always underperform the market when costs are taken into account. In contrast, active managers can potentially deliver market-beating returns by carefully choosing the stocks they hold.

It’s also commonly argued that passive strategies can’t shield investors from periods of volatility. After all, if the market a particular fund is tracking takes a dive, so will the portfolio’s value.

But supporters of passive investing argue that many active fund managers fail to consistently beat the market over the longer term. And trying to pick the ones who will is extremely difficult, as a manager’s past performance should never be viewed as indication of their future returns.

Even Warren Buffett, the world’s most famous stock picker and CEO of Berkshire Hathaway, has previously praised passive investing.2

Given that developed markets such as the US and the UK are so widely researched, it’s particularly difficult for managers to spot opportunities that others have missed, so opting for a passive fund could make more sense. In contrast, regions that aren’t as well known, such as emerging markets, are generally the subject of far less analysis. In these areas, markets tend to be less efficient and many have suggested that the specialist knowledge and experience of a fund manager might be beneficial in hunting out attractive assets.

Find out more about active and passive funds

The rise of smarter strategies

Passive investing continues to evolve. Many fund groups are now offering smart-beta or strategic beta ETFs, which aim to bridge the gap between active and passive investing by using sophisticated stock-picking strategies and alternative index construction, while keeping costs low.

Most benchmark indices, such as the FTSE 100, use a market-cap weighted approach – as in, the 100 largest UK listed firm make up the index. But a smart beta fund focusing on the blue-chip index will use different filters, for example, it could track stocks based on the value of the dividends they pay.

While the long running argument between the two styles carries on, arguably the point is being missed. While passive investments should be at the top of the list for investors building a portfolio from scratch, both investment strategies have their place.

Nevertheless, all investments, whether actively or passively managed, can fall as well as rise in value and you may get back less than you invested.

The benefits and risks of passive investing | Barclays Smart Investor (2024)

FAQs

The benefits and risks of passive investing | Barclays Smart Investor? ›

The popularity of passive funds is growing, attracting investors with the promise of dramatically lower costs than actively managed alternatives. The value of investments can fall as well as rise and you could get back less than you invest. If you're not sure about investing, seek independent advice.

What are the pros and cons of passive investing? ›

Passive investing has pros and cons when contrasted with active investing. This strategy can be come with fewer fees and increased tax efficiency, but it can be limited and result in smaller short-term returns compared to active investing.

What are the advantages and disadvantages of passive and active management of an investment fund? ›

Active investing
Active fundsPassive funds
ProsPotential to capture mispricing opportunities and beat the marketConvenient and low-cost way of gaining exposure to certain assets/industries
ConsFees are typically higher and there is no guarantee of outperformanceNo opportunity to outperform the market
2 more rows
Sep 26, 2023

Is it better to be an active or passive investor? ›

For example, when the market is volatile or the economy is weakening, active managers may outperform more often than when it is not. Conversely, when specific securities within the market are moving in unison or equity valuations are more uniform, passive strategies may be the better way to go.

What are the 3 disadvantages of active investment? ›

Though active investing may have potential advantages over passive investing, it also comes with potential limitations to consider:
  • Requires high engagement. ...
  • Demands higher risk tolerance. ...
  • Tends not to beat benchmarks over time.

What are the pros and cons of investing? ›

Investing in stocks offers the potential for substantial returns, income through dividends and portfolio diversification. However, it also comes with risks, including market volatility, tax bills as well as the need for time and expertise.

What is the disadvantage of passive income? ›

Cons. Some passive income streams, like buying a rental property, require a large financial investment up front. In the beginning, you may need to put substantial time and energy into establishing a passive income stream.

Is passive investing a high risk? ›

Advantages of passive investing

Consistent and low-risk returns — Because of the extreme diversification in most passively traded funds, investors will usually see a consistent return on their investment with generally lower-risk active management.

Can you sell passively managed index funds at any time? ›

This means that you have the flexibility to sell your index funds whenever you want , whether it 's during market hours or after hours . However , it 's important to keep in mind that the value of index funds can fluctuate based on market conditions , so it 's important to carefully consider the timing of your sale .

Why should I invest in passive funds? ›

Passive mutual funds, as a long-term investment strategy, prioritise maximising the returns by minimising frequent buying and selling. Unlike active investing, which aims to outperform the market, passive investing involves holding a diversified mix of assets that mirrors specific market segments.

Why is passive better than active? ›

So passive funds typically have lower expense ratios, or the annual cost to own a piece of the fund. Those lower costs are another factor in the better returns for passive investors. Funds built on the S&P 500 index, which mostly tracks the largest American companies, are among the most popular passive investments.

How often does passive investing beat active investing? ›

Active Funds Fell Short of Passive Funds in 2023

Less than one out of every four active strategies survived and beat their average passive counterpart over the ten years through December 2023. One type of active investment strategy generally trails in long-term success rates.

Why is passive investing becoming more popular? ›

Funds have been flowing out from active funds into passive funds over the past few years, partly due to the poor performance of some active funds, Carey Hall said in a phone interview. Passive funds usually have lower fees than their actively managed counterparts.

What are the cons of passive investing? ›

Critics of passive investing say funds that simply track an index will always underperform the market when costs are taken into account. In contrast, active managers can potentially deliver market-beating returns by carefully choosing the stocks they hold.

What is the active investor risk? ›

Active risk (tracking error) is a function of the portfolio's exposure to systematic risks and the level of idiosyncratic, security-specific risk. It is a relevant risk measure for benchmark-relative portfolios. Absolute risk is the total volatility of portfolio returns independent of a benchmark.

Who manages the fund in passive investing? ›

As the name implies, passive funds don't have human managers making decisions about buying and selling. With no managers to pay, passive funds generally have very low fees. Fees for both active and passive funds have fallen over time, but active funds still cost more.

What are the problems with passive investing? ›

The Danger of Passive Investing for Markets

That is, in a market downturn, there may be a rush for the exits as both passive and active investors get out of large cap stocks. This may become even more of an issue as passive funds continue to take market share from active peers.

What are 5 cons of investing? ›

Cons of investing in stocks
  • Costs. Stock purchases typically involve commissions and fees, which can consume a large portion of your investment. ...
  • Volatility. Stock prices can fluctuate dramatically over short periods, sometimes within just minutes or hours. ...
  • Lack of control. ...
  • Information risk. ...
  • Liquidity risk. ...
  • Counterparty risk.

What are the pros and cons of defensive investments? ›

Defensive stocks provide stable, consistent earnings and dividends. They're less susceptible to factors that affect the rest of the stock market. They're much less risky but gains aren't likely to be as substantial, particularly during bull markets.

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