Passive funds explained

If you’re interested in investing and keep coming across the term “passive funds” but aren’t sure what that means, you’re in the right place. Keeping track of and managing investments can be time-consuming, and if you want to invest but have limited time, passive funds may be a good option for you. On this page, you’ll learn about what passive funds are, how they work, the risks involved and how they differ from active funds.

A passive fund is an investment vehicle that tracks the stock market, a market index or specific area of the market. Unlike with active funds, a passive fund don’t have a fund manager deciding which securities to invest in. This typically means passive funds are cheaper to invest in than active funds, where the fund manager is active in researching and analysing investment opportunities.

The main objective of passive funds, which are also known as tracker or index funds, is to deliver returns that are in line with the current stock market. The goal isn’t to beat it, but simply to replicate the movement of the market the fund is tracking.

Passive fund managers don’t pick which investments to hold in the fund, meaning that any returns will depend on the performance of the index the fund is tracking. If the stock market or index you’re tracking fails, so will your fund. If it rises, your fund will rise as well.

A commonly tracked market in the UK is the FTSE 100, which is an index of the UK’s 100 largest companies based on their market capitalization. A passive fund will purchase shares in all of the 100 companies that are proportionate to their value in the FTSE 100 index. Thus, the fund can replicate the performance of the index. It will also change in its composition, if there are changes in the composition of the FTSE 100 index.

For example, let’s say you invest in a passive fund that tracks the FTSE 100 index. You can do so by buying an ETF, which is short for exchange-traded fund. You’ll typically pay an annual total management expense ratio (the amount varies, but is likely to range between 0.1% and 0.85%) and you know that the fund will mimic the performance of the FTSE 100. You check back and discover that the FTSE 100 rose by 5%, meaning your investment will do the same thing. By contrast, if the performance of the FTSE 100 fell by 5%, then your investment will also fall by 5%. The fund will always have the same variations as the index being tracked.

Although ETFs and index funds are both low-cost options compared with most actively managed mutual funds, there are some key differences you should be aware of. ETFs are typically more flexible than most index funds, as they can be bought or sold at any time, whilst index funds can only be traded at the end of the day.

ETFs may also have lower minimum investments and be more tax-efficient than many index funds. This is due to the way they’re structured, as when you sell an ETF, you’ll typically be selling it to another investor, so capital gains taxes belong to you alone. Conversely, to redeem cash from an index fund, the fund manager will sell securities from the fund in order to pay you. If there are net gains from this sale, this is passed on to every investor with shares in the fund – so you could owe capital gains taxes even when you personally haven’t sold a single share.

With any type of investment, you should ensure you understand all the risks involved. For passive investments, these include:

Concentration risk: By diversifying your investments, your exposure to any one type of asset is limited, and the volatility of your portfolio is reduced over time. But because investments in an index fund are typically made up of top stocks and sectors and weighted according to market capitalisation (for example, the FTSE 100), this can lead to concentration risk because what happens to the biggest  stocks in the ETF will likely affect the performance of the ETF overall. Therefore, if just a few stocks perform poorly, the whole ETF could go down.

Tracking error: Whilst the passive investment portfolio aims to create returns that mimic a particular index, there can be marginal deviances. Thanks to costs such as brokerage fees, securities transaction tax, and expenses of the scheme, the funds end up generating returns which differ slightly from  the index they are following. The tracking error of an ETF is usually very small and should not exceed one per cent per annum. 

Liquidity risk: Both ETFs and index funds face liquidity risks. For ETFs, this is because they can only be bought and sold on the stock exchanges, and they can only be sold if there is enough demand, which, in extreme market scenarios like a crash, is not always the case. For index funds, if your index is made up of stocks that are niche or not particulary popular, liquidity might be limited and selling shares of the fund may have to be executed at a discount.

As with any type of investing, you’re never guaranteed profitable returns because of the volatility of the stock market. If you’re looking for a risk-free way to grow your wealth, opening a high-interest savings account might be a better option for you.

A fund manager takes a hands-on approach in managing active funds, as the goal of an active fund is to beat the market and take advantage of short-term fluctuations. It involves using deep analysis of market stocks, and needs in-depth expertise to know when to move in and out of particular stocks, bonds or assets. An active fund manager will handle the fund and determine where to invest, based on small changes in the stock market. However, studies have shown that active funds cannot beat the market over longer periods of time and because of their higher fees, perform worse than passive funds.

Passive funds are limited to a specific index, while active funds don’t necessarily follow an index. With an active fund, you can use various investment techniques, such as short sales and put options. These techniques are specifically designed to allow fund managers to move in and out of a stock whenever they see the risk increasing (or decreasing). Investing in a passive fund means that you’ll have to remain in line with the index, regardless of whether it appreciates or depreciates.

Active funds tend to have higher fees because all their actions (such as buying and selling) trigger transaction costs. You’re also covering the cost of a fund manager, as well as the analyst teams researching market equity. All these fees can accumulate and might end up being greater than the returns you gain. In passive funds, because you’re simply following the index and nobody picks which stock you should purchase, you don’t incur as many fees.

The active versus passive investing debate has been dividing the investment world for decades. As we’ve already seen, there are pros and cons to both strategies, but which option comes out on top? The truth is that it’s difficult to come to a definitive conclusion; what suits one investor may not suit another. 

If you don’t have a financial adviser and haven’t got the time or inclination to research active funds, then passive investing might be the best option for you. You can keep fees to a minimum and you won’t need to worry about lagging behind the stock market. There’s also evidence to suggest that passive funds may perform better than active investment funds over the long term.

However, if you’re keen to take a more hands-on approach and seek out a reputable fund manager, active investing might be suitable. Although actively managed funds generally have higher fees, that’s not to say there aren’t competitive rates out there – you just need to do your homework. Also remember that a fund manager’s recent strong performance shouldn’t be taken as a guarantee of future success. Instead, look for someone who has consistently outperformed over a long time.

If you’re still not sure where you stand on the active vs passive debate, bear in mind that you don’t necessarily have to decide between the two. You might want to diversify your portfolio by investing in a combination of both active funds and passive funds.

Some passive funds have an annual management charge which can be as low as 0.1%. This fee is lower than active funds, which typically charge around 0.75%, because passive funds don’t need an active fund manager to make investments. 

However, as with any type of investing or savings vehicle, it’s important to compare a range of options before you commit. Fees can vary considerably and even small differences can have a big impact on your returns over time. For example, let’s say you invest £10,000 into a passive fund with an annual fee of 0.1%. If you enjoy 4% growth every year, after 20 years your initial investment would be worth a total of £21,493*.

However, if you invested the same amount invested in a passive fund with an annual charge of 0.5%, your investment would grow to £19,998* over the same period. That’s a difference of nearly £1,500 as a direct result of the higher investment charge.

It’s also important to remember that just because a passive fund has higher fees, it won’t necessarily perform better. The fee structure can be determined by a variety of factors such as the asset classes invested in and the reputation of the fund manager.

*Calculations based on www.candidmoney.com/calculators/investment-charges-impact-calculator

Passive funds may be right for you if you’re looking for a long-term investment with the potential to generate good returns, and you aren’t comfortable with higher-risk investments. Before investing in any fund, it’s important to determine how much risk you’re willing to take. Don’t forget that the stock market goes down as well as up, so you could stand to lose some or all your investments.

If you decide you don’t want to take the risk of investing, you might want to look at other options, such as high-interest long-term savings accounts with competitive interest rates. Putting your money into a savings account comes with a lot less risk than investing in the stock market. You can still earn a competitive rate of interest, especially if you’re prepared to lock away your cash for a few years, and you’ll have the peace of mind that your money is safe as long as your deposits are protected.