Investment Basics

So let's deal with some background first. Active funds have a fund manager who actively chooses the investments which the fund will own, based on the mandate he or she is given. The manager's aim is usually to out-perform the benchmark that the fund is based on - whether that is UK or emerging market equities, fixed interest investments, or anything else.

Passive funds, on the other hand, do not have a manager making choices, since the aim of a passive fund is, generally, to perform just like the index or benchmark. So a passive fund might simply own the same shares as those which make up the index, and in the same proportions. The FTSE 100 is a good example. Then you are (more or less) guaranteed to behave like the index (although there is normally some "tracking error").

Without active management, passive funds are cheaper to run, so the charges to the investor are lower. Proponents of passive funds will say that they are better since the average active fund does not, in fact, out-perform its benchmark over the long term. And so the lower charges mean a better longer term return from passive funds.

So where does that leave the investor trying to decide where to put their money? The answer is that it depends how you intend to invest. As independent financial advisers, Prime Time Financial's view is that both have their place. If you are making the fund choices yourself without a great deal of knowledge, or you intend to "invest and forget", then a passive fund is more likely to be the best approach for you.

But with expert knowledge and regular reviews of your investments (whether you do that yourself or use a financial adviser) you will not be investing in an "average" fund. That means you have a good chance of doing better than a passive fund which simply emulates a benchmark or index.

But you do have to make sure that the extra performance is sufficient to cover the higher costs, including of course any financial advice fees. Our analysis suggests that with typical fund charges and advice fees, an active fund needs to out-perform its index by something like 1.6% to 1.9% every year to provide a better return than a passive fund.

About the Author

Peter Lawrence is an Independent Financial Adviser with Prime Time Financial based in Fleet, Hampshire. He specialises in advising over-50s on all aspects of finances including retirement planning, investments, equity release, and estate planning (Inheritance Tax).

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