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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.

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The rundown
  •  A passive fund is an investment vehicle that tracks the stock market to find good investment options
  • Passive funds depend on the performance of the index they’re linked to, and fluctuate according to that index
  • Passive funds can be lower risk than active funds because an active fund requires constant vigilance from a fund manager

What are passive funds?

Passive funds*, also known as tracker or index funds, are an investment vehicle that tracks the stock market to determine where to invest to maximise returns. The main objective of passive funds is to deliver returns that are in line with the current stock market. The goal isn’t necessarily 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.

How does passive investing work?

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 share value. A passive fund will purchase shares in all of the 100 companies that are proportionate to their market value. After determining the value of the fund, it will move according to changes in the value of the FTSE 100 index

For example, if you invest in a passive fund that tracks the FTSE 100 index, you’ll pay a 1% management fee, 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.

 

What are the risks of passive investment funds?

The main risk you’ll encounter when you invest in a passive fund is in purchasing too many small numbers of stocks. Since passive funds are designed to follow well-performing indexes, the portfolio of the fund will usually contain a small number of high performing investments. If the value of these investments suddenly falls, it can quickly cause the value of your fund to drop as well.

Passively managed funds: the pros and cons

Pros Cons
The performance of the fund will always match the market index, whether it rises or falls, which is considered a safer option. Passively managed funds can never beat the market because they simply mimic the index they’re invested in, which means they won’t make as much money as funds which come with greater risks.
Investing in a passively managed fund will generally cost you less than investing in actively managed funds. Passively managed funds don’t always have a human manager to update the portfolio or tell you when market conditions change.
Passive funds are relatively tax-efficient due to their ‘buy and hold’ strategy, which means you’ll incur less capital gains tax than those who actively invest. When investing in passive funds, your options are limited, which means there won’t be a lot of variance in your investments.

What’s the difference between active and passive funds?

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. 

The main difference between active and passive funds is the flexibility to move in and out of a specific index. 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 fails. 

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. 

Active funds have higher risks than passive funds because fund managers will generally make investments where they think they’ll gain high returns. The outcome can mean you lose money if their choice is wrong. 

What are the fees on 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 because passive funds don’t need an active fund manager to make investments.

Is a passive fund right for me?

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 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 long-term savings accounts with competitive interest rates.

*https://www.investopedia.com/terms/p/passiveinvesting.asp

**https://www.londonstockexchange.com/indices/ftse-100/constituents/table?lang=en

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