Active vs passive investing – which option is best for the US?

For investors who don’t have the time or knowledge to research individual investments, we think a fund could be a great option. They allow you to get exposure to a wide variety of investments.

There are two main types of funds – active and passive. But which approach should you consider when investing in the US?

This article isn’t personal advice. If you’re not sure what’s right for your circumstances, ask for financial advice. All investments can fall as well as rise in value, so you could get back less than you invest. Past performance isn’t a guide to the future.

You should only invest in a fund if its objectives are aligned with your own, and there's a specific need for the type of investment being made. You should understand the specific risks of a fund before you invest, and make sure any new investment forms part of a diversified portfolio.

Active and passive funds – what are they?

Active funds aim to outperform an index over time. An index is usually made up of a range of securities like shares or bonds and represents the performance of a particular market. It reflects the ups and downs of each underlying holdings price. For example, the FTSE 100 index represents the largest 100 companies in the UK.

Active funds have fund managers who conduct detailed analysis of each company, bond or other asset they choose to invest in. They’ll try to determine the best time to buy and sell each investment. This is typically research-intensive which usually means they come with higher costs than passive investing.

Instead of trying to beat the index, passive funds simply aim to track its performance. Passive fund managers usually buy assets in the index, and normally in the same proportions, while trying to keep the difference in performance between the fund and index as small as possible over time. This approach is often simpler, and usually incurs lower fees than active funds.

One of the key things a fund can offer an investor is diversification – spreading your money among different investments to help reduce risk. So how does each approach impact diversification when investing in the US?

Diversification

Let’s take the S&P 500 as an example. As the name implies, this index tracks the performance of the largest 500 US companies. If you were to invest in a passive fund tracking this index, you’re investing in hundreds of companies.

500 different companies is a lot and it does offer diversification, but that doesn’t mean it’s enough – it’s worth digging a little deeper. The index itself is weighted by each company’s market capitalisation – the value of all its shares on the stock market put together. The bigger a company is, the more its stock price movements can move the index.

And some companies in the US are much bigger than others.

In the S&P 500, the top ten stocks make up 27.8% of its total value. Nearly 7% is just one company alone – Apple.

And 26.4% of the index is made up of information technology stocks. That’s not counting Amazon (classed as consumer discretionary) or Alphabet Inc (classed as communication services) which both separately make up over 3% of the index each. So, a big part of the index you’re buying is technology and could be more than you’re comfortable with tying your fortunes to.

S&P 500 by sector

Source: S&P Global, correct as at 30/9/22.

Active funds can be more balanced by giving a stronger weighting to companies that aren’t in the top ten or different sectors from the index. Many stocks in the index might not be held at all.

However, they can also take a concentrated approach. This means holding a high proportion of their investments in certain stocks and sectors like tech, making things less diverse.

It will depend on the fund and manager as to which approach they take. So, it’s worth checking which strategy any active fund manager uses before investing. You can find the number of holdings on the fund factsheet for a fund. This is also reflected in the risk summary on a fund’s key investor information document.

More on diversification

Performance potential

The US is home to half the global stock market and two of the biggest stock exchanges. And because of that, it’s one of the most widely researched markets.

Large US stocks are covered by multiple analysts. Which means any changes to the performance of the company, based on opportunities, or challenges it faces will usually be reflected in the market price quickly. And therefore, the overall index that these stocks make up.

This can make it difficult to find stocks at the right price, whether they’re undervalued or have great growth potential. And subsequently outperform the index.

You might think, if there’s no room to outperform the index, a passive fund might be the best option to access the US.

But it is possible. There are active fund managers out there who’ve demonstrated they can outperform their benchmarks in the US.

Investing using a passive fund means your investment will track the market. But tracker funds tend to underperform when you take things like transaction costs and management fees into account. This difference in performance is known as tracking error.

Unlike tracker funds, in turbulent times, an actively managed fund can make calls which try to lessen the impact on volatility. They can actively avoid stocks that could be impacted by events, or find stocks that could benefit from that economic climate. So, your investment could reduce less in value, or do better than the index.

Though that’s not guaranteed, an actively managed fund could underperform a passive fund.

Active fund managers can also take a long-term view, making decisions that will benefit the fund in the future. They can try to find companies with the capacity to grow in the future or that are undervalued and can be bought for a fair price.

They’ll have different styles though, which often perform differently in different economic climates. So, a manager focusing on finding undervalued companies can deliver when companies like this are in favour, but the opposite is also true.

You could however choose a mixture of active funds which have different styles to compensate for this.

So, what’s the best approach?

We believe there’s a benefit to both active and passive investing, and you don’t have to pick one or other. You can blend both active and passive funds together in your portfolio, gaining exposure to the US and take the benefits of both approaches.

Both have a role to play in building a diversified portfolio.