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Active Versus Passive Investing

Passively managed mutual funds have been all the rage in recent years. They’ve taken market share from their active counterparts across the board, with $662 billion in inflows worldwide in 2017, according to Morningstar’s 2017 Global Assets Flow Report released on May 21, 2018.

However, as with any fund or asset, investors must do more than just follow the crowd. They need to understand the differences between “passive” and “active” mutual funds so they can make informed decisions moving forward.

First, some definitions

Passively managed index funds use an algorithm to give the investor a return – positive or negative – based upon an index, minus the fee. Examples of the indexes used in passive funds include the S&P 500 index (top 500 companies in the U.S.), European stock indexes such as STOXX Europe 600, government bond indexes, etc. There are dozens of different indexes fund companies can use to construct a portfolio.

No human being is making a judgment as to the quality of the investment. For example, a computer knows that Apple makes up approximately 4% of the total value of the S&P 500 index, and your investment in the index mirrors that. Therefore, if you have $10,000 invested, you have $400 invested in Apple.

The beauty of this investment path is typically low costs, as it does not require hands-on management by an adviser. According to Investopedia, index funds typically charge around 0.25% on total investment, where a $100,000 investment would typically charge $250 per year. But such expenses often vary significantly between funds.

Actively managed funds work on the premise that experienced professionals can evaluate investment options and craft a portfolio that can strive to outperform an index. Because there is a hands-on stock picker involved, though, these types of funds typically entail greater fees. Investopedia estimates that “a good, low expense ratio is generally considered to be around 0.5%-0.75% for an actively managed portfolio, while an expense ratio greater than 1.5% is considered on the high side.” So, with a $100,000 investment, a 1% fee would amount to $1,000. In terms of how it works, while the passive indexed fund has no choice but to buy 4% of the $10,000 in Apple, the actively managed fund may decide that more or less (or none) should be invested in Apple.

The growth in investor interest in passive funds has come at the expense, to some extent, of active funds: Morningstar’s 2017 Global Asset Flows Report also estimates that U.S. investors in 2017 pumped $470 billion into passive funds even as they pulled out $175 billion from actively managed funds. Several factors are driving this, including investor desire for lower-fee products and services, as well as perceptions that actively managed funds actually underperform against the indexes. For example, according to the S&P Indices Versus Active (SPIVA) funds scorecard, over the five-year period ending Dec. 29, 2017, 84% of large-cap funds underperformed relative to the S&P 500.

That may appear to be a scathing indictment of active management, but I would suggest the active-versus-passive debate is not an all-or-none proposition – there are, after all, active funds (16%, if we go by SPIVA’s statistics) that do outperform the indices.

As with any investment decision, working with an adviser to evaluate your options and tailor a customized strategy will help you make the right decision for your circumstances.

My discussions with clients

For example, a client recently shared with me her employer’s 401(k) investment options. Conveniently, each asset category provided both a passive and active fund, but she said she planned to move all her allocations to the passive funds because they have lower fees, and she “read that is what she needs to do.” I explained, however, that the active funds her employer provided have actually been quite productive over the past five to 10 years, and maybe they have earned her business. I assured her no one can guarantee solid performance will continue, and many of the passive apostles would suggest it cannot, but long-term performance is always important to consider.

Ultimately, every investor has the choice to invest assets in both types of funds – and as with any investment strategy, diversification is key.

The moral of the story is do your homework. Be open-minded. Do not place blind faith in any strategy, and do not assume everything you read is definitive. Life, and investing, can be a little gray.

source: fool.com

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