Can you get more out of your investments by switching funds?

UK investors have been pouring money into passive funds lately – £3.8bn in April alone, according to Investment Association data published last week. 

Investment funds can be an easy way to spread your money across hundreds of companies.

But they come at a price – usually an annual percentage-based fee, which is typically higher for actively-managed funds, where the fund manager picks investments.

April saw the highest fund sales since 2021, but none of this investing enthusiasm was found in active funds which, according to the same data, leaked £1bn that month. 

Here, Which? dives into the data to discover the difference between the two types of investing, and which is worth your money.

Please note: the content contained in this article is for information purposes only and does not constitute financial or investment advice.

What is the difference between active and passive investing?

Active funds have investments chosen by a fund manager or team specifically, while a tracker or index fund invests passively, meaning it follows a specific index and invests in everything on it.

Passive returns therefore mirror the overall performance of that type of investment – for example, if you invest in a tracker fund following the FTSE 100, you will capture the highs and lows of every company listed. 

Passive funds have been growing in popularity in recent years, at the expense of active funds.

Laith Khalaf, head of investment analysis at AJ Bell said, ‘The ongoing shift towards passive investing has been partly driven by the melt-up of the biggest stocks in the US market producing strong performance from index trackers. Investors are now more benchmark aware, cost conscious, and many just want a simple option to plonk in their pension. Passive funds very much fit the bill.’

Investors are primarily looking for funds that are cheaper and perform better and so, at the moment are choosing index funds.

• Find out more: Investment funds explained

Are passive funds cheaper than active funds?

Generally speaking, you pay lower fund fees for a passive fund compared to an active fund. 

Fees vary between sectors (see graph below), so the gap between fees – and therefore the potential savings – can be bigger for some types of funds compared to others.

For example, the difference between the average fund fee for a passive UK equity income fund is 0.16%, compared to 0.82% for an active equivalent, according to Morningstar Direct. This is a much larger difference than UK gilt funds, which charge 0.11% for passive and 0.22% for active.

• Find out more: Are fund charges eating into your returns? 

Are passive funds better than active funds?

If it were only that fees are cheaper, it would be a more tightly fought contest between the two types of investment, but passive funds have been out-performing in recent years, too.

The difference in performance has been most pronounced in funds investing globally or in North America over the last year. This is driven primarily by the high performance of indexes in recent years, which can be seen especially in the S&P 500 – which tracks large US public companies. 

If an active fund manager invested in US stocks and hadn’t picked the ‘Magnificent Seven’ tech stocks – like Apple, Nvidia, and Tesla – they’d have fallen massively behind the index.

In the last year, investors in active global funds would have average returns of 15.7% compared to 19% for passive equivalents.

But, the gap is not so stark in other sectors, for example in UK Equity Income funds, the average returns over the last year were 12.8% for active funds compared to 13% for passive.

However, if you take a longer term look at the performance of active and passive funds, the difference isn’t so clear-cut.

While investors would still have been better off, on average, putting their money in passive funds based on North American equities over the last ten years, the average investor in global funds would have actually had better success with an active fund.

Though, unlike passive funds, the success of an active fund will also depend on the individual team or manager behind it and therefore will vary depending which fund you choose.

While it can be helpful to see what’s happened in the past to returns, it’s important to remember that past performance shouldn’t be seen as a guarantee for the future.

There are other reasons to go for active funds ahead of passive, like if you’re investing with a specific strategy or theme in mind.

Ethical investors, for example, will find active funds are better suited to investing for positive impact, as passive ethical funds will only ever be able to exclude companies from indexes.

• Find out more: Ethical investing explained 

How to invest in funds

• If you’d struggle to navigate investments yourself, speak to an independent financial adviser who can pick funds for you to invest in based on your goals and needs
• If you’re happy to choose investments yourself, open either a stocks and shares Isa or general investment account with an investment platform
• Always read the Key Investor Information Document (KIID) of a fund to see how it is investing your money and how risky the fund is, all platforms will have to provide this document when you buy into a fund
• Make sure you have a good balance of investments, either within a single ‘multi-asset fund’ or across several funds that cover a range of asset types and locations