Should you be active investing or index investing?
In reality, the two can work well together. Both approaches have different strengths and can be used in different ways depending on what you're trying to achieve.
This article isn’t personal advice. If you're not sure what is right for you, ask for financial advice.
What are active and index funds?
For investors who don’t have the time or knowledge to research individual investments, funds can be a great option.
Investing in funds means your money is spread across multiple investments. Because some investments will perform better than others over time, diversification can help spread risk and smooth returns.
Remember, investments and any income from them can rise and fall in value, so you could get back less than you invest.
There are two main types of funds – active and index.
Index funds – these aim to track the performance of an index like the S&P 500 or FTSE All-Share. Rather than trying to pick winners, they simply follow the market, making them a straightforward and often lower-cost way to invest.
As companies grow and make up a larger part of an index, index funds will naturally have more invested in them. Because no investment decisions are being made, index funds are often referred to as passive funds.
Active funds – these take a different approach. Fund managers research investments and choose those they believe have the best chance of performing well over the long term. This typically involves more research and decision-making, which often results in higher costs. Outperformance isn't guaranteed though, and even successful fund managers will go through periods of weaker performance.
Why consider a blended index and active approach?
The question isn't which way of investing is better, but where each can be most useful.
Index funds can provide broad exposure to markets at a low cost, making them a useful starting point for many portfolios. Active funds can be used more selectively in areas where investors feel a manager's expertise could make a difference.
Combining the two can offer the best of both worlds.
One way of doing this is through a ‘core-satellite’ approach. This involves having a large amount invested in ‘core’ holdings, with smaller investments in other, usually more niche, areas acting as ‘satellites’.
While a few large, global funds could form the core of a portfolio, the satellites can be used to personalise a portfolio. For example, an investor might choose a particular fund manager, a specific theme or geography, or investments that reflect their personal beliefs.
Both active and index funds can be used within the core and satellite portions of a portfolio.
When might investing in index funds make sense?
Not all markets are created equal. In some areas, it can be difficult for active managers to consistently outperform after fees.
For example, large, well-established companies are often closely followed by analysts and investors around the world. Because so much information is readily available, it can be harder for active managers to uncover opportunities others have missed. Global developed markets and US large companies are often an example of this.
That can make index funds an attractive option. They offer a simple and low-cost way to invest without having to identify an active manager capable of outperforming over the long term.
It’s worth looking under the bonnet of an index fund though. Some indices might have more invested in certain countries, sectors or even individual companies. Understanding this can help investors decide whether an index fund provides the type of exposure they're looking for.
That doesn't mean active managers can't succeed in these markets. Some have strong long-term track records. But finding those funds may take more time and research.
When might active funds add value?
In other parts of the market, active fund managers might have more opportunities to stand out. In some niche corners of the market, you may even struggle to find a passive fund to invest in.
Smaller companies, emerging markets and specialist sectors can be overlooked. This creates potential opportunities for active managers to identify promising businesses and avoid those they believe face greater challenges.
Active managers can also be flexible when markets move. They can increase or reduce their investments over time and avoid areas of the market they find less attractive.
This flexibility can be particularly useful in bond markets.
Bond indices typically have greater exposure to the biggest borrowers. Active managers can instead choose the bonds they want to own, giving them greater control over how they invest and the risks they take.
Of course, active management doesn't always outperform. But in some areas of the market, active managers may have a better chance of beating the market.
What’s right for me?
Rather than choosing one over the other, investors should consider how active and index funds can work together in a portfolio.
There's no one-size-fits-all approach to investing. The most appropriate mix of active and index funds will depend on your goals, time horizon and attitude to risk. But for many investors, combining the two can be an effective way to build a diversified portfolio designed to meet their long-term goals.
When it comes to choosing a fund, there are thousands of options available. Our Wealth Shortlist helps narrow the choice by highlighting funds that we believe have long-term performance potential. It includes both active and index funds and can help investors in building a well-balanced portfolio.