Should I use active or passive funds in my Stocks and Shares ISA?

The 2008 Global Financial Crisis led to a huge change in the world of investing. For decades, investors would put their money in active funds.

They’re like baskets full of investments selected by investment professionals who aim to beat the market, and deliver superior returns to their clients.

Since the financial crisis, investors’ appetite has changed. In droves they’re ditching their investments in active funds for the rising star of the investment industry – passive funds. Unlike active funds, passive funds are designed to track the market and mimic its movement, meaning your returns should stay on track with the market performance.

When we build your Stocks and Shares ISAs, we have a tool kit that includes both. In this article, we’ll lay out what active, and passive funds look like, the pros, and cons of each, and why we use both in our Stocks and Shares ISAs.

What is an active fund?

Active funds at one stage were the only option for investors who wanted to own a broad basket of investments without the hassle of purchasing tens, or hundreds of underlying investments to build a diversified investment plan.

Investors would employ a group of investment professionals, known as fund managers, to pick stocks and bonds with the objective of performing better than the wider financial market.

An active UK equity fund for example, would purchase shares of companies, and be tasked with the objective of beating the performance of the FTSE 100 – the average performance of the top 100 companies listed on the UK stock market. In return for their hard work and expertise, fund managers are paid an annual management charge.

It was in 1868, one of the oldest widely known active funds, The Foreign & Colonial Investment TrustFund¹ was established.

What is a passive fund?

But, it took over 100 years for passive funds to get recognised beyond academic research as an investment product.

In the late 1970s, investing legend John Bogle created one of the first passive funds, the First Index Investment Trust - later renamed to Vanguard 500 Index Fund.²

As the name of the Vanguard fund suggests, passives (also known as index trackers) are funds designed to mirror the collective returns of a financial market, rather than beat the broader market like active funds.

The most well-known passive funds track huge global stock markets like the FTSE 100 in the UK, or the S&P 500 in the U.S. What’s less commonly known is passive funds track, or mirror, a whole host of financial markets. Here at Wealthify we use passive funds to invest in alternatives like commodities and private equity.

The pros and cons of using active funds in a Stocks and Shares ISA

The benefits of using active funds in a Stocks and Shares ISA

1. Active funds could deliver outsized returns. Active funds are a good option for investors who desire more than average market returns from their ISA. It’s an active fund manager’s job to perform better than their benchmark, which is typically the wider market, so in theory, active funds are the right investment for investors chasing higher returns. Whether they deliver on their promise of higher returns is a different matter.
2. Active funds can be shaped for a niche requirement. If investors want something more bespoke than an off the shelf investment solution, looking in the active fund isle of the supermarket could be a good idea. When we build an ethical Stocks and Shares ISA we typically prefer active funds for their bespoke qualities. Ethical investment strategies include analysis on metrics that are subjective, like how a company’s operational activities affects the environment, and in our opinion, this type of analysis still requires the human touch.
3. Easier than picking your own stocks and bonds. When it comes to building your own Stocks and Shares ISA, investing in active funds is an easier route compared to selecting individual investments. Active funds are a big basket of investments; therefore, one fund could hold more stocks than you could financially afford to buy as individual stocks, or bonds. 

The negatives of using active funds in a Stocks and Shares ISA

1. Active funds aren’t cheap. If you’re cost conscious, active funds used in your Stocks and Shares ISA can be expensive compared to other options available. According to Which³, the total annual cost of owning an active fund is on average 0.85% versus passives that typically range between 0.20% and no fees. Assuming a 0.10% charge for passives, the active fund has to deliver 0.75% more than the market each year to remain level. Yes, if you find an amazing fund manager, or need a certain fit of investments, the extra cost can be worth it. But, if you don’t tick those boxes, the alleged value you’re receiving for the added cost can be questionable.
2. They can often fail to beat the market. An active fund held in your ISA has the objective to perform better than the wider financial market, but outperformance is rather rare. Studies have repeatedly shown that it’s incredibly hard for a fund manager to perform better than the wider market, consistently over a long-time frame.
3. The necessary chore of inspecting the fund manager’s holdings. The Neil Woodford story is a good case study of why investors on an ongoing basis need to inspect active funds’ holdings when managing their own Stocks and Shares ISA. What happened to the Woodford UK Equity Income Fund is known as style drift⁴, changing the type of shares being purchased. When this happens, a fund has the same name, same fund manager, but underneath it isn’t the same fund.

The pros and cons of using passive funds in a Stocks and Shares ISA

The benefits of using passive funds in a Stocks and Shares ISA

1. Passive funds are low in cost. If you’re looking for a way to access potential investment returns in your ISA at a low cost, passive funds are the only gig in town. It has reached a point where some large fund managers in the U.S. are offering access to passive funds free of charge! Even in the UK, investors using passive funds that track huge global stock markets are being charged less than 0.10% on an annual basis – here we’re talking about the fund charge.
2. Passive funds are diversification kings of ISAs. For the small fee you pay, they provide access to hundreds and sometimes thousands of underlying investments. Investing in passive funds that own so many holdings helps with the diversification of your Stocks and Shares ISA. Diversification is important for long-term performance because it minimises the impact of any poor performance from a particular investment type or region.
3. They’re rules-based, simple, and transparent. If you’re busy with a family, career, or social activities, you probably don’t want the ongoing responsibilities that come with owning individual stocks, or active funds, in your Stocks & Shares ISA. Passive funds that track markets like the FTSE 100 are a Ronseal investment - it does what it says on the tin. The fund you purchase in your ISA should continue to mirror the returns of the market it tracks for infinity.

The negatives of using passive funds in a Stocks and Shares ISA

1. There’s no emotional protection when markets aren’t performing very well. Passive funds are rules-based, and light on human involvement. Yes, it’s typically a lot cheaper than using an active fund and it delivers similar results. But, when markets are experiencing turbulence, irrespective of what academic studies suggest, and the added cost, it’s a natural feeling to want a human being in charge of your investments. Why? Because albeit small, there’s a chance the active fund shields you from the worst of the downturn! With passive funds that’s not an option. Investors have to deal with the emotional experience of watching their hard-earned investment pot fluctuate with the ebb and flow of the market. Here at Wealthify, we combine the best of both worlds as we have an experienced investment team who actively manage passive funds.
2. Passive funds are designed for long term investors, not short-term speculators. Most passive funds track huge global stock markets. Companies in these stock markets are usually older, established companies with more predictable returns, meaning you need to commit long-term if you’re looking for potential significant growth. But, long-term is exactly how an investment strategy should be treated, focusing on a time-horizon that exceeds 5 or even 10 years will soften the emotional impact of witnessing any short term volatility in your investment plan. Besides, if you focus on long-term investing, and couple it with contributing little and often, the power of compounding income can have a powerful impact on investment returns.  
3. There are some elements of investing that passive funds can’t replicate. As previously mentioned, at Wealthify we use active funds for our ethical ISAs. The human involvement in this circumstance is a benefit because the fund managers running the active funds will vote on socially sensitive matters like executive pay, and collaborate with other active funds to drive positive change at a company.

Passive funds are rules-based, the light touch involvement is great for cost but when you have specific, or bespoke requirements, it can mean they aren’t the right fit for you.

Why we use passive funds in our Stocks and Shares ISA

As a low-cost investment solution, passive funds allow our investment team at Wealthify to build you a stocks and shares ISA invested across various different investment types, worldwide, whilst aiming to keep costs as low as possible.

We’ve pointed out the benefits of the human touch with our ethical funds. But our Original ISAs have just as much of that benefit – all our Stocks and Shares ISAs have the Wealthify Investment team managing the investments on a daily basis - we are the human touch!

We actively manage all of them, ensuring our customers are in the right regions, using the best funds available. We use passive funds because they’re a great way to generate investment returns at a fraction of the cost of active funds. All this evidence supports our preference to use passive funds when we build what we call our Original ISAs, giving you access to thousands of underlying investments for a modest fee, and low minimums.

Why we use active funds in our Stocks and Shares ISA

Whilst we think passives are great building blocks for our original ISAs, when it comes to ethical ISAs, we still prefer the human touch.

The primary reason we prefer active funds is because we don’t think replicating an index of top-rated companies, delivers a truly ethical approach to investing.

A crucial part that is missed out of ethical investing through passive funds is the fund manager’s engagement with the company. Active funds will collaborate together to help drive positive change in business practices of the companies they invest in, something you don’t get with passive funds. This is why they’re typically more expensive.

But, as ethical investing is a subjective matter, we feel that paying a little more for human involvement in managing the fund is the right approach to merge financial returns with ethics in the best way possible.

Summary

As an investment manager we like to use both active and passive funds in our ISAs, but for very different purposes. When used correctly, and in a disciplined approach, each style can complement each other. Alternatively, if you’re looking for something a bit more focused, or bespoke, like an ethical investment solution, we think active funds still trump passives in that area.

To wrap up, there are pros and cons to both passive, and active funds. At Wealthify, we use both and believe that the question shouldn’t be as simple as whether to use passive, or active funds.

Instead, it should be centered around when to utilise the benefits of each investing style in your Stocks and Shares ISA.

References:

1. ^{https://www.thisismoney.co.uk/money/investing/article-2695778/How-did-26-investment-trusts-26-years.html}
2. ^{https://www.foxbusiness.com/personal-finance/vanguards-index-funds-a-history-of-evolution-for-investors}
3. ^{https://www.which.co.uk/money/investing/types-of-investment/unit-trusts-and-oeics/are-fund-charges-eating-into-your-returns-as43q0j6wsrq}
4. ^{https://financial-dictionary.thefreedictionary.com/Style+drift}

With investing, your capital is at risk.

The tax treatment depends on your individual circumstances and may be subject to change in the future.

Please remember that with investing, the value of your investments can go down as well as up, and you could get back less than invested.

Wealthify does not offer financial advice. Please seek financial advice if you're unsure about investing.