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Investing in active and passive funds – when and how to blend them in a portfolio?

We take a closer look at active and passive fund management and how the two strategies could work together.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

A well-rounded portfolio diversifies across a range of different investments, sectors and parts of the world. Having a good mix of shares and bonds offers a strong foundation for investors to weather the ups and downs of the stock market. But knowing which investments to pick, and how to blend the two can be tricky and time consuming.

For investors who don’t have the time or knowledge to research individual investments, we think a fund could be a great option. Funds can be a great way to diversify as they usually invest in a wide range of different investments.

There are two main types of fund: active and passive. In this article, we explore the benefits of both approaches, and explain how active and passive funds can form important parts of a diversified portfolio.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. All investments and any income from them can fall as well as rise in value, so you could get back less than you invest.

What are active and passive funds?

Active funds aim to outperform an index over a period of time. The fund managers conduct detailed analysis of each company, bond or asset they invest in and will 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.

Successful active management means being right more than you’re wrong. Not every actively managed fund is going to outperform though. Even successful active managers will have periods of both outperformance and underperformance.

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 in the same proportions, while trying to keep the difference between the fund and index as close as possible over time. This approach is much simpler, can be lower risk and usually incurs lower fees than active funds.

What about a blended approach?

It can be tough to decide between the two. Is it worth paying up for the chance to outperform the index with an active fund? Or is it better to keep costs low and simply tracking the index with a passive one?

Passive funds can be a convenient and low-cost way to invest in a chosen stock market. Active fund managers have flexibility to sort the good from the bad, investing only in what they believe are the best opportunities. Some active funds also take a more defensive approach and can minimise the impact of a market downturn.

The good news is it doesn’t have to be one or the other. We think the sweet spot is a blend of the two.

When to go active or passive?

Certain markets provide greater opportunities for active managers. For example, small and medium sized companies tend to receive less attention from brokers and large institutional investors. That opens the door for skilled active managers to try and spot companies with exciting potential that have flown under the radar.

Larger companies tend to receive more limelight and are often priced more efficiently. That means there’s less chance to buy a share for lower than it’s actually worth. This can make it more difficult for active managers to consistently outperform. We think the right active managers can still add value here, but a low cost, passive approach could also be well-suited.

Investors should also consider the characteristics of an index – for example does it have lots invested in a certain country or sector? This could influence the choice between a passive and active approach to that market. You might prefer to invest more in some areas that an active fund is investing in compared to a passive fund that’s investing more broadly.

Similarly, fixed income indices are weighted towards the biggest issuers, in other words those with the largest amount of debt. Increased exposure to issuers with a greater amount of debt is a higher risk approach. Active managers can pick bonds and construct portfolios that reflect their own preferences, which could offer a better risk / reward trade-off.

Getting the most out of an active approach all depends on selecting the most talented fund managers. If the manager selects the wrong shares or bonds, performance could be below the index and an equivalent passive fund.

Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

What’s right for me?

Instead of considering whether to invest entirely in active funds, or entirely in passive funds, investors should think about how to best harness the advantages of each strategy. Passive funds could form a low-cost portion of the portfolio for broader, more efficient markets. Whereas active funds could be used in parts of the market where there’s perhaps more scope to outperform.

When it comes to choosing a fund, there are thousands of options out there. Our Wealth Shortlist filters narrow that universe down to funds we believe have the best potential for long-term growth across the major sectors.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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