Passive funds are a type of investment vehicle which track a market index or a specific market segment. In any passive fund, the manager does not make the active decision in which exact securities they want to own.

Examples of passive funds would include tracker funds, such as ETFs (exchange traded funds) and index funds, essentially any fund that tracks an index such as the S&P 500 or the FTSE 100.

EIS Fund Twenty8

The benefits of passive funds

Traditionally, actively managed funds have been a favoured tool, with fund managers actively seeking investment opportunities for generally high net worth clients. However, in the fifteen years up to 31st March 2016, only 29% of actively managed funds had beaten the S&P 500 index.

CNBC and Bloomberg have both written extensively about the popularity of passive funds in the last couple of years, with figures stating that over $90bn was invested into debt ETF’s alone in the last year.

One of the key factors in the increasing popularity of passively managed funds has been the costs associated with actively managed funds, which require paying a healthy fee to the fund manager. In recent years, many have started to doubt whether the ‘wins’ achieved by investment managers outweigh the costs and this would appear to be backed up by the research quoted above, which shows that a minority of actively managed funds beat the S&P 500 index.

By their very nature, passive funds require less effort, so are a becoming a popular vehicle for those who do not always have the time required to chase new investment opportunities.

They benefit from an ease of trade and a high level of transparency. Passive funds such as ETFs can be bought and sold at any time during the trading day, show all the underlying assets and a priced at regular intervals throughout the day.

In terms of minimising costs, it is clear that they have advantages over actively managed funds and certainly would appear an option for investors looking to track the market conditions.

The downsides of passive funds

Despite the number of investors who have flocked to passive investing in the last few years, there are some downsides of passive funds, which do not exist with an active approach to investing. There is the potential to miss out on high return investments if you invest in a passive fund, whereas the active fund manager will seek to outperform an index. After all, why try to perform at index level, when you can outperform it?

Rob Morgan of Charles Stanley Direct notes in this article that sector diversification could be low as some indices have a large concentration of one particular sector, which could leave investors exposed to any decline.