A fund is just a collection of shares. They are much less volatile than owning shares in individual companies, and you don’t have to pay the buying/selling costs as you do when trading shares. This is a significant advantage if you are dealing with small amounts.
Actively managed funds aim to beat the market. There are thousands available (in the US they actually outnumber the companies they invest in), with many different focuses. For example:
FTSE All Share (UK stock market)
S&P 500 (US stock market)
Equity Income fund.
Each fund will be managed by a fund manager, buying and selling shares in companies which meet the criteria of the fund.
These funds can be quite costly to own, with fees over 1% in many cases. This may not sound high, but if the long term returns are 4%, you lose a quarter of that in fees. If in a given year the fund loses money, which happens, you still pay the fee.
An advantage of active funds is the huge variety available. For example if you wish to avoid investing in oil and tobacco for instance, you can select a fund which excludes these.
The main disadvantage is the cost, which is much higher than passive funds. Statistically, over time, most actively managed funds fail to beat the market.
Since this June, Neil Woodford’s Equity Income fund has been frozen. Like many hundreds of thousands of people I hold this fund, in my ISA and pension. It’s one of the largest in the UK, and Neil was referred to as a ‘rock star fund manager’. I suspect he is called many other things now.
The fund is frozen since it was performing badly, and there was a run on investors selling. One council tried to sell over £250 million it had invested as part of its pension fund. Neil had moved away from the purpose of the fund (the FCA failed to take any action or warn investors), buying unlisted (not on the stock exchange, therefore you can only sell if there happens to be a willing buyer) and illiquid investments (hard to cash in). Therefore these payments couldn’t be made and the fund was frozen.
As a result many people will lose significant amounts of money. Some with pension funds won’t even know they’re affected.
Neil’s reputation may be in tatters, but the £20+ million he has pocketed over the last 3 years, despite his performance may soften the blow.
A result of this could well be an increase in the already significant move to passive funds. This could also make some low-performing fund managers up their game to keep their customers, which has to be a good thing.
Where active funds aim to beat a specific part of the market, index funds just aim to match it, by holding shares in the companies within the index. So a FTSE 100 index will hold shares in the top 100 companies in the UK stock market. This is far more straightforward, probably automated, and therefore fees are much lower. Not all index funds pay dividends. Some reinvest the dividends from individual company shares as part of their returns.
I mostly use Vanguard, who’s founder invented low cost index funds. Some of the funds have fees as low as 0.06% (and Vanguard have just lowered their fees on a range of funds). This has a huge effect on compounded results over years, when compared to 1% or above.
One disadvantage which hadn’t occurred to me until today, is that the index funds have to hold all the companies within the index. This may include companies you are uncomfortable investing in, such as tobacco and fossil fuel companies. There are several ‘ethical’ funds available, some of which have performed as well as their ‘unethical’ comparators.
Personally I’m not sure that avoiding owning shares in such companies actually has any effect on them, unless you hold enough (such as a large pension fund) to be able to influence their practise. I may be wrong.
Another disadvantage could be that they hold the shares in proportion to the market capitalisation (theoretical value) of each company within the index, rather than holding larger amounts of the better performing one.
When choosing a find you usually have the choice of Income to Accumulation versions. The latter automatically re-invests the dividends. The Income version pays the dividends, though your chosen platform should allow you to automatically re-invest them.
I keep changing my mind (and my portfolio) as to whether I prefer active or passive funds. When I started out on this journey last year, I have a few £k in a mix of active funds. Thinking I was being smart, I looked at some of Hargreaves Lansdown’s managed portfolio (collections of funds), and rather than paying the extra level of fees, I just bought the same funds in the same proportions. This is how I ended up with Woodford’s Equality Income fund!
Anyway, having read considerable amounts about passive investing, mostly from the FIRE community who advocate cheap, hands-off investing, I moved to a range of passive (mostly Vanguard) funds. However, I had a couple of Japan active funds, which were up about 35% in 3 years, and have continued to rise since I sold them.
Overall my portfolio is still up (on most days) since I switched to passive funds, but maybe it would have been up more. Who knows.
The key I suppose is diversification. Currently my portfolio is split between UK, US, Global and Developing world. That covers pretty much everything!
I also have a few bonds, and shares in 3 companies and a REIT (which gained 12% in a couple of weeks but have fallen back a bit). I also intend investing more in property, though that will depend on the results of the general election!
The SP500, which covers much of the US stock market, has gained an average of 8% pa for decades. Therefore people who have heavily invested in SP 500 passive funds have done very well. This includes many of the US FIRE commenters. The question of course is can this continue? Within the FIRE community there seems to be an assumption that it will. Many people are expecting a stock market crash, though from what I’ve seen this has been the case for the last few years.
Short term crashes are not a problem if you are investing for the long term, and don’t need to live off the income from your investment. However historically the market has always picked up. This may not always be the case. In How to Own the World, … argues that the US’s days as world economic leader are numbered (I tend to agree), and that future growth will be in emerging markets (China, Russia, Brazil, India etc). There is also the issue of limited resources. Continued growth requires continued increases in use of natural resources. This is clearly unsustainable.
Only time will tell who’s right, by which time it’s too late for the inevitable losers. I think the best we can do is keep a diversified portfolio.