Could plumping for a passive fund be a long-term mistake?

More and more investors are putting their faith in passive funds, but this could lead to unforeseen issues.

When the time comes to invest in the stock market, many of us opt for a fund. It’s a simple way to invest in a range of different companies - rather than picking individual stocks and shares, you invest in a host of them via the fund.

There are broadly two types of fund. Some are actively managed, with a fund manager who is picking those stocks and shares to invest in and attempting to get the best possible return.

But there are also passive funds, which just track against an index, like the FTSE 100. They are called passive funds – they try to mirror the performance of an index, often by investing in all of the firms within that index.

You’ll never beat the index with a tracker, but you probably won’t finish too far off it either.

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Investors are going passive

Some experts are worried about how many of us are going for passive investments though.

New research from Royal London makes clear just how important passive investing has become. It found that passive investing in shares now accounts for nearly half of all assets under management, while fifteen years ago it accounts for only a percent or two of those assets.

There are plenty of reasons behind that. The first is that the cost of investing in passive funds has fallen significantly over that period.

Research from the Financial Conduct Authority last year found that the average fee charged by a manager of an active fund is 0.9% a year, before all admin and trading costs, while the average passive fund charges a paltry 0.15%.

All investors, no matter how experienced they are, need to carefully consider the cost of their investing. And with passive funds becoming so cheap, it’s little wonder that more investors are plumping for them.

There’s also been the question of performance. If you’re putting your money in an active fund, then you would hope that you’re going to outperform the market. But the reality is that an enormous number of actively managed funds fail to do that.

So faced with the choice of paying more for a fund that is likely to fail to meet the benchmark, and paying a pittance for a fund that will more or less replicate the index, it’s easy to see why investors are going passive.

Another incredibly important factor in the growth of passive funds is that they are simple to understand. And for people just starting out with investment, that’s a huge draw.

The unexpected consequences of investors going passive

There are potentially some unforeseen issues that come from so many investors going passive, however, according to Royal London.

For example, there is a danger that you will be locked into shares that are performing poorly, simply because they are part of an index.

With an actively managed fund, you’d hope that the fund manager would spot the dogs they have invested in and clear them out. But with a tracker, you’re going to keep pumping money into shares in iffy firms, until they drop out of the index altogether.

There is also a question of diversifying. Now, on the face of it putting your money in an index fund is in itself a way to diversify - you’re investing in all of the firms across the index, which can cover many different industries.

But in reality, being unable to invest outside the benchmark hurts your diversification. It also points to research which argues that when shares become part of an index, they start to perform more in line with other shares in that index, even if they didn’t before.

The final big downside is that there is less accountability when it comes to the people running the businesses that appear in these indices.

When shares are actively owned, management knows that if they underperform, the shareholders may sell up and take their money elsewhere.

That isn’t a realistic risk when most of those shareholders are in that position through passive funds.

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Why I’ve been a passive investor

When I take a step back, I realise that I am exactly the sort of investor that this report is concerned about.

I’ve been only too happy to stick the bulk of my pension in tracker funds, knowing that while they’ll never beat the market, they should more or less follow it, and that’s good enough for me.

Investing has always been the area of finance that has seemed the most opaque to me.

Like any responsible young(ish) person, while I know that I should invest my money, that lack of transparency leads me to lean on tracker funds rather than think long and hard about an actual strategy or whether I really want to rely on a ‘superstar’ fund manager (that mere phrase is like nails down a chalkboard to me).

And honestly, I don’t regret that decision.

Will passive go too far?

Of course, all of this comes down to whether passive investing becomes even more dominant than it already is. And I can certainly see that happening, particularly if robo advice becomes more popular, given that those firms often stick the money they manage into passive funds.

But investors cannot be blamed for searching for value. Investment remains utterly bewildering to many of us, and so long as active funds charge more for a less impressive performance, investors will continue to be turned off by them.

The challenge is therefore for the actively managed market to deliver, and show investors what they are missing out on.

Do you think fears over passive funds are justified? Let us know in the comments section below.