Passive funds have soared in popularity, rising from £28 billion to £298 billion over the last 15 years, according to BMO. As a result, they now account for nearly 20% of total funds in ISA and other portfolios.
I’ve historically invested most of my ISA in active funds in the belief that a good fund manager should beat the return from passive funds. But, given the number of tracker funds topping the performance tables, I’ve started to question this strategy. I’m going to take a closer look at the battle between active and passive funds for ISA portfolios.
[top_pitch]
What are active and passive funds?
Essentially, active funds aim to outperform the stock market by buying and selling stocks. Whereas passive funds (also known as ‘index’ or ‘tracker’ funds) mirror a benchmark such as the FTSE 100 or MSCI World Index.
There are two types of passive funds:
- Exchange-traded funds (ETFs) quoted on the stock exchange and traded at ‘live’ prices.
- Funds bought and sold ‘blind’ as they’re forward-priced.
Fees vary significantly. Passive funds charge annual fees of 0.1%-0.2%, compared to 0.5%-2.0% for active funds. This may seem marginal, but it can reduce the value of your ISA by thousands of pounds over the long term.
But I’m happy to pay higher fees if my active ISA funds deliver superior returns. Let’s see whether this is the case.
Have active funds out-performed passive funds?
According to Morningstar, 50% of active funds across all categories outperformed their average passive peer in 2020. However, only 25% of active funds beat their passive rivals over a longer 10-year period.
That said, performance varies considerably by sector. BMO’s Multi-Manager PassiveWatch reports that, for the first time in seven years, an active fund managed to beat its passive counterparts in the US market over 10 years. Whereas the active UK mid-cap sector was one of only two sectors to buck the trend, beating their passive rivals over three, five and ten years.
However, it’s also worth considering the degree of out-performance for ISA investments. According to Trustnet, the top-performing UK active fund was CFP SDL UK Buffettology, with a 10-year return of 253%. This is almost twice the 10-year return of 127% achieved by the top-performing Xtrackers FTSE 250 UCITS ETF passive fund.
Looking at the UK All Companies sector as a whole, the top 10 active funds delivered 10-year returns of 185%-253% according to data from Trustnet. This compares to 90%-127% for the top 10 passive funds, illustrating the lower spread in returns.
Overall, passive funds have typically outperformed active funds. However, some of the best-performing active funds have also delivered far higher returns than their passive peers.
Three changes for my ISA portfolio
It’s tempting to believe I can beat the passive trackers by picking the best fund managers for my ISA, but this is difficult in reality. Hugo Cox from the Financial Times comments that “The existence of the fund management industry depends on this triumph of hope over experience, relying on our propensity to cling to the handful of big-name performers.”
However, a blended approach should provide me with the best of both worlds.
1. Picking trackers for large-cap ISA funds
Laith Khalaf from AJ Bell comments that “Within the Global and US sectors, active funds have failed to bring home the bacon compared to index funds.” He also notes that global tracker funds “increasingly resemble US tracker funds, making it more difficult for active funds to compete”.
Investing in passive funds tracking a range of indices should deliver consistent returns for my ISA without the challenge of trying to pick ‘next year’s top fund manager’.
2. Invest in cautious active funds in market downturns
Passive funds can have limitations in volatile markets. An active fund has the flexibility to shift into different types of stocks and sectors, which may provide better returns in a market downturn.
So, I’m also going to add some active total return funds to the defensive funds in my ISA. These aim to deliver modest growth while limiting the downside risk in falling markets.
3. Keep active funds in niche sectors
I’m also going to keep the faith with active small-cap funds in my ISA, as there’s a more limited choice of passive funds in this sector.
My highest-performing small-cap fund is Liontrust UK Micro Cap, achieving a five-year return of 93% according to Trustnet. The most comparable passive fund is the Vanguard FTSE UK All-Share Index, which delivered a return of 23%.
Laith Khalaf comments that the smaller-cap market is “a fertile hunting ground for active managers to pick out hidden gems, as they are not as well scrutinised by the wider market.”
[middle_pitch]
How can you invest in funds?
ISAs are a good way of investing in funds as they are free from Capital Gains Tax.
Many of our top-rated ISA providers, such as Hargreaves Lansdown and Interactive Investor, offer a wide choice of active and passive funds.
