Active funds vs passive funds

Retail investors often ask what is better, a passive fund or an active fund. With lots of market commentary about index funds, let’s take a look

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

These days, a lot of column inches are dedicated to index fund, or passive, investing. On inspection, it is easy to see why. They have added a welcome element of simplicity into the investing equation. An index fund will aim to match its respective market. No more and no less.

Seal of approval

Index funds have been given the nod of approval by legendary investor Warren Buffett, in part due to the low-cost nature of the funds. Normally, these funds charge the investor a comparatively small fee, which is sometimes under 0.1%. Many investors see the natural diversity of the whole index as a benefit, too.

Index funds were pioneered by Jack Bogle. He saw a need for retail investors to get close to mirroring the market, rather than stock picking via a mutual fund and potentially underperforming an index’s results. He wanted investors to reap the rewards of the markets, rather than see the profits being eaten up by financial elites.

Recently, there has been noise about how index investors could be creating a bubble. Leading this conversation is Michael Burry, of The Big Short fame. Burry has concerns that retail investors are buying funds without careful analysis of the underlying companies. He fears this could lead to the companies being valued on the same terms.

Setting aside Burry’s concerns, I wanted to juxtapose index funds with their natural competition for many retail investors’ cash: active funds.

As the name suggests, an active fund is a mutual fund that is being actively managed. For example, the manager of the fund might see a buying opportunity for tech stocks, and plough money into them, moving away from another area, like mining. In a turbulent market, they may even reduce their position in stocks and hold a cash reserve. In return for this active management, these funds usually charge higher fees.

A big bet

In 2008, Warren Buffett famously held a bet. He reckoned that over 10 years, an index fund would outperform a collection of hedge funds. He put his money where his mouth was, stumping up $1m, to go to the chosen charity of whoever the winner might be. Protégé Partners took up the bet and chose a portfolio of handpicked funds. Buffett’s choice won.

Eagle-eyed readers will note that in 2008, the markets tanked. The actively managed funds were able to adapt to the market conditions, while Buffett’s money sat riding the market storm. Buffett’s fund lost 37%, and Protégé’s lost only 24%. At the end of 2016, however, Buffett’s fund had returned just over 7% a year, to the 2.2% gained by Protégé.

Is there a right answer between choosing an active or passive fund? As always, it depends on your situation. But I think that for investors who are willing to stick it out over 10 years, an index fund is hard to beat.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

T Sligo has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

 

More on Investing Articles

Investing Articles

3 of my top FTSE 250 stocks to consider buying before April

Buying undervalued UK shares can be a great way to generate long-term wealth. Here, Royston Wild reveals a handful on…

Read more »

Ice cube tray filled with ice cubes and three loose ice cubes against dark wood.
Investing Articles

Just released: our 3 top income-focused stocks to buy before April [PREMIUM PICKS]

Our goal here is to highlight some of our past recommendations that we think are of particular interest today, due…

Read more »

Investing Articles

Is this the best chance to buy cheap FTSE 100 shares in a generation?

I want to buy shares when they're cheap, and sell... never, just keep taking the dividends. And the FTSE 100…

Read more »

Man putting his card into an ATM machine while his son sits in a stroller beside him.
Investing Articles

Could NatWest shares be 2024’s number one buy for passive income?

For those of us looking to earn some long-term passive income, how does NatWest's 7% dividend yield sound? It sounds…

Read more »

Investing Articles

£12K in savings? Here’s how I could turn that into £13K annual passive income

This Fool explains how investing a lump sum can help her build a passive income stream to enjoy in her…

Read more »

Aerial shot showing an aircraft shadow flying over an idyllic beach
Investing Articles

Here’s why Rolls-Royce shares are now set to fly over the £4 mark

Once again, Rolls-Royce shares are crushing the FTSE 100. Should I add to my holding of this stock at the…

Read more »

Investing Articles

1 under the radar FTSE 100 AI stock investors should consider buying

Our writer explains why this FTSE 100 pick could be a shrewd investment with its established experience of using AI…

Read more »

Investing Articles

Does the beaten-down Diageo share price make it a no-brainer buy?

Harvey Jones spent years waiting for the Diageo share price to look like good value, before finally buying it in…

Read more »