I get asked about today’s topic on a pretty regular basis so I thought now would be a great time to discuss active and passive mutual funds and ETFs. I am including exchange-traded funds because, in recent years, some ETFs have become active. In today’s blog, I am going to explain the difference between active and passive funds as well as some of the pros and cons of investing in these types of funds. Whichever one is right for you, let’s make the choice a financially simple one!
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Before we get too far into which is a better investment option, we need to understand what it means when we say a fund is active or passive. Essentially, active funds have a manager or a management team that oversees the investment. They choose securities (i.e. stocks and/or bonds) that they expect to outkick the coverage, so to speak. These are holdings that are expected to add value to your portfolio or to simply perform better than expected.
On the other hand, passive funds have no manager to make investment decisions. Typically, the investor will track the index and make their own choices based on their own data and research. So which way is better? Well, they each have their own pros and cons to consider before making an informed investment decision.
As I mentioned before, investors track the market index to determine which stocks they want to invest in. But what is the purpose of the index? With just under 4,000 exchange-traded stocks, an index has two major functions. The first is simply to measure the overall stock market performance. The other function of the index is to serve as the benchmark for an individual investor’s portfolio performance. In theory, the average of an index’s performance should mirror the overall stock market’s health.
There are several different indices in the U.S. that measure different collections of stocks:
Apart from the major equity indices, there are several fixed income indices as well. These are used to gauge the overall performance of the market or market index. For example, if the S&P 500 gains 0.8% in a month, while the S&P SmallCap 600 gains 1.7%, you might hear that small-cap stocks outperformed large-cap stocks by 0.9% Therefore, an index is just a way to gauge the performance of a small slice of the proverbial stock pizza pie.
In order to succeed in passive fund investing, you need to understand indices. This is because passively managed funds are often defined by the index they track. For example, a fund that tracks the S&P 500 buys and sells stocks as they are added to and dropped from the S&P 500 index.
You must also understand that turnover ratio matters. For example, a mutual fund investing in 100 stocks and replacing 50 stocks in a single year has a turnover ratio of 50%. Passive funds also buy and sell stocks to maintain the same weighting as the index, which is based on market capitalization in the case of the S&P 500. Because there is little turnover ratio, there is often lower taxation. However, this is not always the case.
Passive funds usually have lower expense ratios than that of there active counterparts. What’s an expense ratio? Well, let’s say you invest in a fund that has a 1% expense ratio. This means that for every $1,000 you earn, $10 will be collected by the fund.
Finally, you’ll want to be aware that, at their best, passive funds will match the performance of the indices they track. Often times, they underperform the index they track because of the fees associated with them.
At this point, we understand how indices are involved in passive funds and we know the important points of a passive fund. So what about active funds? How are they different? For starters, active funds CAN OUTPERFORM THEIR BENCHMARK index! If an active fund is attempting to beat the S&P 500 and its index is benchmarked against the S&P 500, it can do so.
Active funds also provide greater flexibility. Active funds have greater flexibility because their managers are not limited by following the index; they can buy and sell whatever securities they think fit the fund’s strategy. When a fund is actively managed, you can be very flexible with your decisions. If you don’t want to sell a particular position today, then don’t sell it. Hold on to it. If the manager thinks they need to buy more of a position, then do so. It’s as simple as that, folks.
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Actively managed funds are able to be hedged. There are funds that utilize options as a hedging tool. Fund managers can hedge their bets by using short positions, futures, or options, whereas a passive fund typically can’t. This is a fantastic benefit to have if the management of your fund believes that the market is going to take a dive. Furthermore, active funds give you the ability to better manage taxes by having more control over when securities are sold.
However, this added flexibility can lead to more risk, as investment decisions are in the hands of human managers who face fewer restrictions.
Asking which is better is really more of a trick question. There is room for both types of funds and comparing the two is similar to comparing apples to oranges. Morningstar produces a semiannual report called the Active/Passive Barometer that measures the performance of U.S. active funds against passive peers in their respective categories.
According to Morningstar’s August 2019 Barometer, 48% of active U.S. stock funds outperformed their average passive peer over the twelve months through June 2019. That is an increase of 11% over the year through June 2018. The report continued on to say that active growth funds saw the biggest rebound in one-year success rates as 66% of such funds beat the average of the passive funds in their categories, an increase from the 44% reported in the previous year.
Active funds saw an increase in eleven of the twenty categories that were examined by Morningstar. All told, 44% of active funds beat the composite for their category in twelve months through June 2019.
Morningstar’s Active/Passive Barometer made the following points on active and passive funds:
I know this is a lot of information to digest but it’s important to understand the benefits as well as the disadvantages of investing in active or passive funds. They each have their place within our portfolios and I wouldn’t give up on either active or passive funds. However, I usually use passive funds on the key core equity positions and active funds in the area of fixed income. Of course, if you worked with us, we would explain active or passive funds in our reporting meetings!
Follow along with more wealth growth ideas in the Investing segment of our Personal Finance for the Business Owner series.