Should I invest with a tracker fund or use an active manager?

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What serves investors’ needs better – active or passive strategies? It’s a question that triggers much debate.

The good news is that you don’t need to come up with an answer. Both have their pros and cons and you don’t have to choose one over the other for all eternity. But at different points in time, one or the other may suit your immediate needs better, but please consider taking financial advice before investing.

Here we look at how both strategies work and the benefits each can bring to a portfolio.

Targeted: Active funds select investments based on an economic view or the outlook for an individual stock

How do active and passive funds work?

The manager will make judgement calls based on their personal view of the market or the prospect of an individual stock. This prompts them to alter their regional, sector or asset allocation, for example they might increase their exposure to banks or reduce exposure to utilities based on economic news.

Sometimes it means they will buy in to a particular stock, for example because it is cheaper or perhaps sell out of one because the investment case has weakened.

Passive managers do not take a view on the market but instead 'track' or mirror an index. They do this either by buying into shares across an index, such as the FTSE100 (the top 100 companies listed on the stock exchange in the UK), or by using complex financial instruments to create a similar effect. 

Which will suit me better?
The choice to opt for passive or active management will reflect the aims of each individual investor and you may decide to go for a blend of the two.

If you go down the active route, you need to have a high level of conviction in the management style – you need to find an active manager whose strategy you can believe in and has a track record of beating their relevant benchmark, although it should be said that past successes may not always be replicated in the future.

However, a passive strategy lifts the burden of making a call on one manager or strategy and instead gives you a flavour of your chosen index as a whole. In general, passive fund fees are lower, which makes a significant difference over time because of the effect of compound interest.

Investors need to remember that while an active manager has the potential to outperform both rising and falling markets, a passive fund will only ever perform in line with how the market behaves. This is why an effective active strategy can really add value.

Many investors - whether they are going it alone or using a financial adviser – could choose a combination of the two, in order to keep costs low, diversify and able to back their investment ideas. 

Following the herd: Passive funds reflect their index's performance but remove the risk of picking an underperforming manager

Benefits of both 

A passive strategy will never significantly beat the index as its job is to reflect it, whereas an active fund can significantly outperform if the manager makes the right calls, but this cannot be guaranteed of course.

An active manager can also give you the opportunity to invest based on your economic views – perhaps you think banks will do well so want to put money into a financials fund, for example. 

And if you are in a situation where you predict indices will fall but that certain sectors will do well, you could be better off selecting an active rather than a passive manager.

On the other hand, a passive fund will give you exposure to the whole index. However, they are by no means risk-free because if the market falls so will your passive investment.

Some markets are more efficient than others so are harder for active managers to 'beat,' often making passive funds a more viable option.

What governs the cost of active management? 

Active managers trade stocks or other types of investments, which costs money. They also have to undertake management research to find out more about companies before they decide whether to invest. 

Some managers also take a performance fee, which usually kicks in when their fund beats its benchmark index by a pre-agreed amount. 

The fee they claim is usually calculated as a percentage of the outperformance, and can significantly erode the returns that this strong performance earned you in the first place.

Passive funds are generally cheaper because they do not have any of these associated costs of a specialist manager, or need to undertake the same level of due diligence and research that needs to be carried out by a stock-picking fund.

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