Active vs. Passive Funds: Which are Better?

For those new to the stock market, all the choices can seem very overwhelming. If you watch TV, you’ll see commercials for discount brokers that allow you to buy and sell stocks by yourself. When you’re driving, you’ll see billboards for mutual funds. If you turn on the radio, you might hear an ad for an investment advisor. And we haven’t even talked about all the promotional material on the internet.

What’s an investor to do?

One of the first decisions you’ll have to make is to decide who’ll manage your money. For a small minority of the population, it may be appropriate to buy and sell individual stocks based on their own research. This kind of do-it-yourself investor is seriously taking matters into his or her own hands. Before going down this path, you need to have two things to ensure you don’t get in over your head: time and expertise. You require the time to spend watching the markets, as well as the expertise to know what you’re doing.

If you don’t have both of these prerequisites, you’ll probably want to have someone else manage your money in some capacity. Investment advisors are a possibility, but they come with annual fees as well as trading commissions. Furthermore, it’s tough to know just how good a particular advisor is. You could end up paying a lot in fees and get low returns in the process.

So if you don’t go the investment advisor route, what’s left?

You really have two options: a fund that is actively managed, or one that is passively managed.

Active vs. passive investing explained

When we think about money managers, we tend to think about people who run mutual funds. Mutual funds, as the name implies, are a way for individuals to invest alongside others, with a professional doing the job of picking stocks. In return for their management, the fund company takes an annual fee, expressed as a percentage of how much you’ve invested.

In recent years, passive investing has become increasingly popular. Whereas actively managed funds attempt to pick the best sectors and the best stocks at any given time, passive funds merely track the overall market or a particular sector. Passive funds are often referred to as index funds or exchange-traded funds (although not all ETFs are passively managed).

To illustrate the difference, consider two funds, each geared towards the Toronto Stock Exchange (TSX). One is a mutual fund and the other is an index fund. The mutual fund will be staffed by a team of analysts and portfolio managers, who spend their days trying to find the best stocks. On the other hand, the index fund is essentially managed by a computer. Depending on how it’s set up by the index fund company, the fund may simply ensure that its holdings track the index as closely as possible.

Which is better?

One of the allures of active management is the possibility that a particular mutual fund will outperform the broader market. Indeed, this is the sort of tantalizing potential that the mutual fund industry uses to attract investors. Every investor would love nothing more than to place their money with a superstar money manager, one who will provide above average returns.

Unfortunately, the studies are pretty clear that over time, most actively managed funds don’t beat the market. Why is this? There are a few reasons. For one thing, because mutual funds are constantly buying and selling stocks, the commissions racked up in the process subtract from the overall return of the fund. In addition, most mutual funds will keep a portion of their portfolios in cash. Given that the market tends to rise over the long run, this means that mutual funds are not fully participating in these gains.

And for individual investors, there’s one more reason to avoid mutual funds: their fees.

Mutual funds in Canada typically charge 2% to 2.50% annually as a management fee. This is known as the management expense ratio (MER). Passive funds, on the other hand, often charge a much more modest fee like 0.3% to 0.5% a year. That’s a difference of as much as two percentage points.

What these hefty mutual fund fees do is take a huge bite out of long-term stock market returns. Going back many decades, equities have tended to return roughly 7% after taking into account inflation. Thus, if more than two percentage points of this 7% is being paid in fees, a large portion of the return is going to the mutual fund company and not the investor. Over time this significantly reduces the overall return of individuals who invest in these kinds of actively managed products.

Another way to think of this is that passive funds allow you to retain the massive difference in fees for yourself. Rather than spending an added 1.7% to 2% in fees for a fund that will likely underperform the market anyway, you get to keep much more of your capital for yourself.

There are many choices when it comes to investing. But in the active versus passive investing debate, the choice is pretty clear.

Flickr: Rafael Matsunaga