When it comes to saving money for the long term – that is, ten years or more – investing your money usually delivers better returns than simply saving it up as cash in the bank. This is why any workplace pension you have, for example, will at least partly be invested in the stock market, and most of the rest will be in bonds.
Most of us don’t have the time, patience or enthusiasm needed to research, buy, and sell individual shares for our own portfolios. This is why most people hand their money to a fund manager to do it for them – the fund manager gathers the money together and invests it in a portfolio of shares. This is known as “active management”.
So far, so good.
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When you invest money with an active fund manager, you want to know that they are using their skill to deliver you the best return they can. In the jargon, you want to know that they can deliver “alpha”.
So if your fund manager is investing in big U.S.-listed stocks, for example, you would probably want to compare the returns the fund gives you with those of the S&P 500. You’d use the S&P as a “benchmark” – a figure that you’d expect the manager to beat over time.
This is where we hit a snag. Because the reality is that a majority of active fund managers struggle to beat their benchmarks – whatever they are – over any decent length of time. That’s partly because they also charge relatively high fees, which they have to earn back before you see any return yourself.
This is where passive investing comes in. Passive funds don’t try to beat a benchmark, they just try to track it. So a passive fund investing in U.S. stocks might just buy all the stocks in the S&P 500 in the same proportion as the index.
Because this isn’t very labor intensive and can be automated, the fees are lower too. So most of the time, an investor will get a better return – and pay less for the privilege – by opting for passive rather than active management.
There are some potential downsides though – to learn more about them, sign up for our Investing Weekly e-newsletter.