Active or passive: the ultimate guide to investing your ISA

One of the biggest ISA investment decisions is whether to buy active or passive funds – or combine the two.

While some investors believe it’s best to invest in an actively managed fund, in which a manager and team of researchers pick the shares they believe will perform best, others prefer to buy a passively managed fund (an index fund or exchange-traded fund – ETF), which mirrors the ups and downs of a specific market index.

Rather than picking one over the other, most investors opt for a mix of the two approaches in their portfolios. But having a good understanding of the difference between active and passive funds is crucial. Let’s start by explaining the basic differences.

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What are active and passive funds?

An active fund has a manager and a team of researchers who select the shares they believe will perform best. The idea is that the skill of the manager, combined with their research capabilities, allows them to identify the shares that are likely to excel, while smoothly navigating what’s going on in the economic background, such as fluctuating inflation and interest rates.

To measure their performance, funds often use a stock market index as a benchmark. This benchmark is chosen to be comparable to the portfolio of stocks that the manager puts together. For example, a manager who buys UK shares may use the FTSE All-Share index as their benchmark.

The return of a fund over a given period is then measured against the benchmark. A fund manager who provides returns higher than the benchmark is said to be “outperforming”, while those providing returns lower than the benchmark are “underperforming”.

There are no guarantees an active fund will deliver outperformance. If it underperforms, investors still pay the fund fee.

Therefore, index funds and ETFs can suit those investors who don’t want to take the risk of an active manager doing much worse than the market. Some investors may be happy to sacrifice the potential of doing better than the market for a more predictable return.

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Is the fund active enough?

With active funds, it is important to look under the bonnet and assess how “active” the fund manager is when attempting to outperform. 

When examining performance, look at a line chart of how a fund has performed versus an index over multiple time periods, such as one year, three years, five years and 10 years. This can help investors grasp whether the fund is providing genuine active management. If the two “lines” look similar over both the short and long term, this should trigger warning bells that the fund manager is not investing sufficiently differently and is “hugging the index”.

Costs

Active funds are generally more expensive as the manager’s salary and resources cost money. A typical active fund will charge somewhere between 0.75% and 1% a year (known as the ongoing charges figure), which is higher than most passive funds, where 0.1% to 0.2% a year is typical. Our recently updated guide reveals the cheapest ways to invest in various regions.

In contrast to active funds, index funds and ETFs simply hold all the stocks in an index. Rather than trying to buy the best shares, passive funds aim to replicate the performance of an index.

A simple way to understand the difference between active and passive is to think of active managers as trying to uncover needles (good shares) in a haystack (the market). Passive funds, meanwhile, buy the whole haystack, knowing that the needles are in there somewhere.

Passive funds come in two forms: index funds and ETFs. The core difference is that unlike index funds, ETFs can be traded throughout the day on the stock market, much like individual stocks. For long-term investors, the difference is not important.

While the purpose of most ETFs and index funds is to track a broad, well-known index such as the FTSE 100 or S&P 500, over the past decade a new breed of passive fund has emerged, which blends elements of passive and active fund management. 

For example, some ETFs now screen stocks based on certain characteristics or “factors”.  For instance, some ETFs track a basket of stocks deemed “value” – that is, stocks trading at cheap valuations. Alternatively, you can buy an ETF that screens for growth or dividend shares. The idea is that screening for these factors will lead to better performance than the market.

Other ETFs follow an index composed of shares related to certain themes. For example, an ETF may track the theme of artificial intelligence (AI). Usually, this entails tracing a pre-made index of companies making a significant amount of their revenue from a particular theme. These types of funds are called thematic funds (our guide below explains this fund type in much more detail).

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Most index funds and ETFs are based on a market capitalisation-weighted benchmark, such as the FTSE 100 or S&P 500. Under this approach, companies are weighted according to their total value relative to the index. Therefore, this results in greater exposure to the larger stocks in the index that have already seen a rapid appreciation in price.

In contrast, active managers have the flexibility to search for “tomorrow’s winners”, such as small companies, that could one day become big businesses.

However, as mentioned above, there are no guarantees that an active fund manager will outperform the benchmark.

Due to the impact of fees, passive funds tend to outperform active funds on average.

For example, the iShares Core MSCI World ETF USD Acc GBP (LSE:SWDA), which tracks the MSCI World index of 1,500 developed-world shares, has risen 272% over the past decade (data to 23 February 2026). This compares with a 201% return for the Investment Association’s (IA) Global sector, which is the average return of global funds, the vast majority of which are actively managed in this sector.

In the UK, the Vanguard FTSE UK All-Share Index Trust is up 150% over the past 10 years, compared with a 106% gain for the IA UK All Companies Index. 

How a fund has performed over a certain time period can reflect whether its investment style has been in or out of favour.

Also bear in mind that a fund flying high over a short-term time frame can be a warning sign that the investment style and approach could be about to come off the boil. The danger here is that fund investors fall into the trap of performance chasing.

Therefore, it’s important to avoid being seduced by strong short-term performance numbers. A useful thing to remember is that past returns went to other investors rather than yourself.

This is particularly important when considering a fund that invests in commodities or a single country emerging market, such as China or India. These funds are more adventurous and tend to go through short-term periods of strong and weak performance. 

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What is best today, active or passive?

Passive funds that follow a market-cap weighted approach – most of them – are destined to own yesterday’s stock market winners. This could prove dangerous if there’s a sustained shift from growth stocks (which have become a large part of global indices) to value stocks performing best. 

The so-called Magnificent Seven, a group of American technology shares, including NVIDIA (NASDAQ:NVDA), Apple Inc (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT), now make up about one-third of the S&P 500 index and a nearly a quarter of the MSCI World Index.

This raises the risk that if the largest stocks falter, passive funds could underperform active funds that chose to ignore these expensive, but high-growth, shares. 

But investors don’t only have to consider an active fund to reduce the risk of US and global markets becoming more concentrated.

There are index funds and ETFs that track an equal-weighted index, which holds each company in equal proportion. For example, an equal-weighted FTSE 100 index would have a 1% weighting to each constituent.

One of the main benefits is that an equal-weighted ETF avoids being overexposed to stocks that have become overvalued or, worse still, potentially part of a bubble.

Examples of equal-weight ETFs for the S&P 500 index include: Invesco S&P 500 Equal Weight ETF (LSE:SPEX) and Xtrackers S&P 500 EW ETF LSE:XDWE). 

However, this approach has its critics, with some arguing that an equal weight ETF would still struggle in a general sell-off but miss out on substantial gains when the biggest stocks do well.