Contrasting risks in active and passive funds—and whether you’re paid for them
To track, or not to track? This is a debate that just will not go away. When “the last humans are roaming the earth, picking through dystopian urban hellscapes in search of food, they will still manage to argue about the relative merits and demerits of passive investing,” mooted FT journalist Katie Martin, in the paper’s Unhedged blog last year. Spoiler alert—I’m not going to resolve this debate here.
We looked at the performance comparisons here last year, and I’m not going to cover that ground again. Instead, we’ll take a brief recap of where bonds and equities stand in terms of assets and flows, then raise some questions as to what this means in terms of risk.
Passive equity fund assets are 40.9% of the total for the asset class, as of October 2025. While that’s considerable, the US figure is well over 63.2%. The rotation with bond mutual funds and ETFs has, however, been more rapid (chart 1). Catalysed by the bond market ructions of 2022, passive bond funds now have a larger percentage of the UK market (43.5%) than their equity peers (chart 2).
Chart 1: Bond Fund Flows, 2020 to October 2025 (£bn)
Source: LSEG Lipper
Chart 2: Bond Fund Net Assets, 2020 to October 2025 (£bn)
Source: LSEG Lipper
Concentration risk
There is a perception that passive funds are less risky than their active peers. That depends on what you mean by “risk”.
First, let’s consider concentration risk—how many eggs you put in the one basket, whether those “eggs” be single stocks, sectors, or regions. For example, the US has a weight of almost 63.01% of the FTSE All-World index (31 October 2025). In December 2008, that percentage was 44.42%. In 2024, the US was the best performing major market, so that larger exposure was both a result of US outperformance, and a benefit to investors: the risk has been rewarded.
This is also expressed at the level of individual markets, most noticeably within US large caps. The Magnificent Seven stocks accounted for 36.6% of the total market capitalization of the S&P 500 in late October. In contrast, the top seven stocks summed to less than 18% at the end of 2008. Again, it’s a risk that investors have been rewarded for: stepping outside these leviathans, and the rest of the US market has been lacklustre (although small caps had a great Q3, so never say never).
Actively managed funds on average, and the largest funds in particular, are broadly in line with the benchmark: concentration risk is comparable between active and passive, although fund selectors can and do chose funds that take positions very different from the benchmark.
Not all errors are mistakes
How can risk relative to benchmarks be assessed? Tracking error (TE) measures the standard deviation of the excess returns of a fund from those of its benchmark. The lower the TE of a fund, the more the fund resembles its benchmark in terms of risk and return.
A tracking error above 2% for equity funds is often considered indicative of active management. However, this can vary by asset class, fund type, and market conditions.
That’s the principle. What does the practice look like? Lipper data shows that the average TE for all actively managed equity mutual funds available to UK investors is 1.7%. Just 29.9% of funds had TEs of 2% or above. Ranked by TE, the first quintile has a TE of 2.92%, the second quintile of 1.99%. Only the first quintile therefore has an average TE of above that conventionally regarded as an actively managed fund.
However, there are good reasons why an investor would want active management with a low TE. A client such as a pension fund may want a fund with a TE as close to a benchmark as possible—for example, the FTSE 100—while excluding specific sectors such as tobacco or coal. While institutional investors tend to be more focused on active risk—“no one gets fired for buying IBM”—the requirements of a retail client may be somewhat different.
Of course, you don’t want your clients to be paying for active management when they are getting passive—or as close as makes little difference. However, it’s also debatable whether a higher TE means better performance. As Warren Buffett said, “We don’t get paid for being busy, we get paid for being right”. And there is a stack of literature a mile high devoted to showing that the market over the long term is right (though the stack for active is likely just as high).
I calculated the correlation of TE to the three- and five-year returns of funds in Lipper’s Equity Global classification, one of the larger data sets. In both cases, the correlation was negative, if small (less than -0.2). That is perhaps unsurprising in a market where returns are dominated by a small number of widely held mega caps. Trying to do something different from the dominant companies can come at a cost in US and global portfolios. That doesn’t mean that it will always be so, and it often hasn’t been the case historically.
Bonds and index risk
Bond indices are harder than equities to replicate due to liquidity and turnover issues. Active bond fund managers have criticised passive bond funds because indices weigh allocations to issuance, so the most indebted entities have the largest positions in vanilla indices. Nevertheless, as we’ve seen, that doesn’t seem to have dented passive bond flows.
There are index alternatives that skew to quality, however. At the sovereign level, for example, the FTSE Debt-Capacity World Global Bond Index has higher weights for countries with lower debt/GDP and debt service costs. The US therefore has a 15% lower weight in the DCWGBI compared to the “vanilla” WGBI. Corporate equivalents, such as the FTSE RAF World Corporate Investment‑Grade Bond Index exist, though these seem to have attracted little fund provider interest. This may be because credit quality has been improving across the board in conventional fixed income indices, reducing default risk.
Ultimately, there is no right or wrong in active versus passive. Indeed, neither is there a significant rupture between active and passive portfolios, but more a gradual shading. While active funds are different from the benchmark, many aren’t that different, and many clients—particularly institutions—want it that way.
This article first appeared in Personal Finance Professional.
LSEG Lipper delivers data on more than 380,000 collective investments in 113 countries. Find out more.
The views expressed are the views of the author and not necessarily those of LSEG Lipper. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. LSEG Lipper cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.
