Understanding Active & Passive Investments

On paper, the argument between active and passive investments is often polarised with commentators debating the merits of each standalone investment type and it is commonplace to see the debate pitched as ‘Active Vs. Passive’.

In reality, most investors will have a blend of the two investment types which form part of their overall investment or pension portfolio.

Therefore, PAS Financial Planning considered it would be useful to provide an overview of each investment type so as to provide clarity on the advantages and disadvantages of both.

Active Investing
Actively managed funds are run by professional experts who make investment decisions on behalf of the fund they manage – and of course on behalf of the investors who invest within their fund.

Active funds have a specified investment objective, for example this may be to outperform the average return of a particular stockmarket or index or perhaps to provide an increasing level of income to investors within the fund.

As an investor, the objective of the fund should correspond with both your own motivation for investing within the fund and should be appropriate for the level of risk you wish to take.

A fund manager may invest the combined assets of the fund into many underlying assets – e.g. stocks, shares, gilts, bonds etc. in order to try and achieve the fund’s objective.

Most importantly, active fund managers operate based on the premise that by utilising their expertise along with thorough analysis and research in combination with a proven investment process they can make qualified decisions in order to outperform the market.

Part of the rationale for doing so is based on the theory that, generally, investors are irrational and their emotion and opinion can create inefficiencies that can be utilised by fund managers so as to achieve above average returns.

However, it should be considered that fund managers charge a fee for the service that they provide and this normally results in active funds being more expensive than the alternative Passive option. Further, there is no guarantee that they will achieve their objective of outperformance.

Passive Investing
Passively managed funds operate in contrast to active managed funds.

Their objective is normally to mirror or closely track the performance of a specified market index – hence alternative names of ‘a tracker fund’ or ‘an index tracker’.

As such, the structure of a passive managed fund will be based upon aligning assets so as to replicate the composition of an index. An example of this is that a passive UK equity fund may invest into the companies that comprise the FTSE All Share index in accordance with the relevant weighting of the many companies that make up that index.

The key to passive investing is that an investor’s objective would be to mirror or closely match the performance of a certain market index rather than trying to achieve outperformance.

The rationale of the passive investor is based on the belief that by the time information can be processed, analysed and acted upon then it is likely that this has already been factored into the price of the asset.

Active Vs. Passive
At PAS Financial Planning we believe it should be a case of ‘Active and Passive’ as opposed to ‘Active Vs. Passive’.

For example, both investment types have their specific advantages with active investors potentially benefitting from above-average performance and investment returns and the opportunity to implement specific investment strategies whereas passive investing typically offers low fund management charges and removes the possibility of significant underperformance when compared to the market.

Despite the apparent necessity to polarise the two investment types it is widely accepted that they can instead be blended to provide portfolio solutions that benefit from the advantages offered by each.

At PAS Financial Planning we believe that this is a key ingredient in formulating a successful investment portfolio – providing a blended solution by selecting proven active funds and combining them with the market exposure offered through passive funds.

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