No money topic is too big or too small. Welcome to the Mouthy Money Podcast,…
Read More →
Passive vs active funds: is there a clear winner?
Investors looking to choose where to put their money should weigh up the costs and performance of passive vs active funds.
Passive vs active funds is an ever-present debate in investing circles. But investors that opted for index funds over the last few years are likely to be happy with their choice.
US and global index funds have given them a significant weighting in the buoyant technology sector.
A select group of active funds have delivered stronger performance than the index, but given the complexity of finding them, most investors won’t be too worried about missing out on a percent or two.
For much of the past decade, the US technology sector has benefited from network effects and economies of scale. The companies have become larger, and a greater share of major indices such as the S&P 500 and MSCI World.
Invariably, for risk reasons, active managers can’t hold these stocks in the same proportion they are found in the index.
Against this backdrop, the number of fund managers that have managed to keep pace with the indices – and therefore passive funds – has been limited.
Passive vs active funds
The latest AJ Bell ‘Manager versus Machine’ survey found that only one third (33%) of active funds have outperformed a passive alternative over 10 years and just 31% outperformed in 2024. Unsurprisingly, active managers found it particularly difficult in the Global and North American sectors, where the technology dominance is most acute.
Investors have, by and large, voted with their feet in the passive vs active funds debate. The most recent Investment Association data shows that tracker funds are now 24.8% of overall funds under management in the UK. This is a rise from just 11.3% in 2015.
That equates to growth from £105.2bn, to £374.4bn. Groups such as Vanguard and iShares with cheap, straightforward products, have proved popular. The higher fees charged by active funds have acted as a drag on performance and a deterrent to investors.
Robert Fullerton, senior research analyst at Hawksmoor Investment Management, says these flows have created a virtuous circle for the share prices of companies that are a large part of the index: “(It) explains nearly all of the recent outperformance of these companies. As well as the continued dominance of the big tech names, it also explains for example the continued outperformance and premium valuations of large vs small cap indices.”
Too big to fail?
But Houston, there is a problem. Such has been the popularity of the index heavyweights in the technology sector, that they have ballooned to a vast size.
Apple’s market capitalisation is now $2.96 trillion, Nvidia’s is $2.46 trillion, Microsoft is $2.3 trillion, while Amazon is a ‘mere’ $1.7 trillion [1]. To put that in context, the whole of the UK market has a market capitalisation of $3.1 trillion [2].
That makes them a huge share of the major market indices. An MSCI World tracker, for example, now has 74% in US-listed companies [3]. An S&P 500 tracker, the preferred approach for many investors to access the US market, has 36% in the top 10 stocks [4].
This is the highest concentration for the US market since the Nifty Fifty era of the 1960s and 70s. That’s great while the party’s rolling but may not look so clever if the technology giants start to wobble.
As Fullerton says: “If or when concentration levels drop, you can reasonably expect these trends to reverse, as passive funds become equally enthusiastic sellers.”
That wobble may be happening. There was the arrival of Chinese AI challenger DeepSeek, which claimed to have trained its AI at a fraction of the cost. This put a dent in the long-term growth assumptions for Nvidia, and for some of the cloud computing giants (Amazon, Microsoft, Alphabet).
Apple is also facing rising costs from Donald Trump’s new tariff regime because so many of its phones are made in China. These tariff wars have sent markets tumbling in recent days.
Simon Evan-Cook, manager of the Downing Fox multi-asset funds, says any pullback could be worse than the unwinding of the technology bubble in the 1990s: “Back then the US made up about half of the global stock market, whereas today it’s around three quarters. And within the US itself, the index is more reliant on its biggest companies.
“On this measure, if there is a pullback in American mega-caps, it could be longer and deeper than the noughties experience.”
Even if everything is fine, it is still poor risk management to have such high concentration in a single stock or sector.
It also highlights one of the key arguments against passive in the passive vs active funds debate. They will tend to prioritise yesterday’s winners. This has been fine when the technology giants kept winning, but it may be a tougher strategy going forward.
Of course, passives are not only on the US market, though that it where they have been most widely used. It may make sense to have passive investments in areas such as developed market government bonds, where active managers generally can’t add enough value to justify higher fees.
In contrast, passive funds tend to struggle in areas such as emerging markets, or smaller companies, where there is less liquidity, more mispricing, and therefore more scope for active managers to add value.
Passive may appear to have won the debate, but the environment may be shifting to favour active managers once again.
Market leadership has broadened out over the past few months, and the technology sector has started to struggle. Investors may want to rethink the balance in their portfolios.
This article is provided for informational purposes only. All investing carries risk and you could lose money. If in doubt seek professional advice.
[1] https://companiesmarketcap.com/gbp/ [2] https://www.ceicdata.com/en/indicator/united-kingdom/market-capitalization [3] https://www.msci.com/documents/10199/178e6643-6ae6-47b9-82be-e1fc565ededb [4] https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overviewPhoto credits: Pexels
