At the forefront of the investment world over the past decade has been the debate over active versus passive investing. Active funds, or mutual funds, have managers that “actively” buy and sell investments in order to beat their respective benchmark or accomplish their specific objective. On the other hand, passive funds have no manager, they simply participate in the market and perform as well as their respective benchmark. While our investment philosophy is geared towards the passive side, there can be a role active funds play in a portfolio. This article will explore the differences between active and passive funds.
What are active funds and what are passive funds?
First, let’s compare what actually qualifies as an active fund and what qualifies as a passive. Mutual funds are most commonly associated with being active funds. As I mentioned, they have managers and research teams who attempt to beat their respective benchmarks. Passive funds include index funds and ETF’s. Both of which don’t have managers that are attempting to beat their benchmark. Rather, they “buy” the benchmark or whatever they’re tracking, and participate in the returns.
For example, if you purchased an S&P 500 index fund, you’ll own every stock in the S&P 500 and perform essentially just as well, for better or worse. On the contrary, an active manager attempting to perform better than the S&P 500, might invest more heavily in technology stocks, or underweight another specific sector. While on the surface this may not seem like such a hard goal to accomplish, but research has shown that the vast majority of active managers fail to beat their benchmarks.
The primary suspect that holds active managers back from beating their benchmarks is fees. It also happens to be the primary reason many investors now choose to use passive, low-cost investments. A typical S&P 500 index fund might charge 5 cents on the dollar annually for participating in its investment returns, whereas an active fund might charge north of 80 cents on the dollar. Over time, these higher fees work against investors. Think of compound interest working in reverse.
The 2017 SPIVA report card below, shows how over extended periods of time active funds can’t beat their benchmarks. The ones that do, likely have managed to lower their fees in order to combat this “disadvantage” they face from the get-go. Over a 15 year period, 92.33% of active managers attempting to beat the S&P 500 failed! That’s resounding evidence to be careful when selecting actively managed funds and to be sensitive to the fees you pay for your investments.
Managing taxes can have a big impact on returns for investors. Another primary difference between mutual funds and index funds and ETF’s are the ability to manage taxes efficiently. Mutual funds have the ability to “kick out” capital gains unexpectedly, which can hurt investors who aren’t expecting it. The higher turnover of investments in the mutual fund results in capital gains that have to be passed on to the investor.
Index funds and ETF’s, on the other hand, allow investors to control their capital gains. Only upon selling the investment itself will the investor realize a capital gain or loss. This enables investors and advisors to plan for taxes more predictably and eliminates unsuspected taxes as a result of a fund kicking out a capital gain.
Keep in mind, this applies to taxable accounts and not retirement accounts, which are tax-deferred. You don’t pay capital gains along the way when you buy and sell investments in retirement accounts, only upon withdrawal will you eventually pay taxes if it’s a pre-tax retirement account.
The Case for Passive Funds
As you can probably tell, I’m biased towards using passive funds. Not only does the academic research support the argument for using passive funds but the majority of new investor money is flowing into them as well. The secret is out and passive funds continue to see massive inflows.
If active funds are periodically able to beat their benchmark or come close in any particular year, what does it matter if you know that it’s eventually a zero-sum game, or potentially worse? When factoring in fees, the bottom line is the vast majority of active funds can’t overcome them – no matter how talented an investor they and their research team are.
It’s more important to focus on your investing behavior, financial goals, habits, and participate in market returns than to chase that extra 1% in return that as research has suggested, becomes more elusive over longer periods of time.
The Case for Active Funds
Now that I’ve successfully hammered on active funds for the majority of this article, let me explain a few potential upsides. As inflows to passive funds have increased, investors are putting money into good and bad investments by participating in the overall market. This can distort prices and theoretically create more opportunities for active managers to take advantage of incorrect valuations. If inflows to passive funds continue to increase, it will be interesting to see whether active managers are able to flip the switch, when presented with the right opportunities and market conditions.
It can be argued that with the rise of the internet and the ability to access information almost instantaneously, markets have become more efficient, effectively aiding the cause of passive investing. Yet, there are particular regions where information may still not flow as quickly as it does in developed nations. For example, some international or emerging markets may be more inefficient, which presents more opportunities for active managers to take advantage of the price inefficiencies.
The Bottom Line
When it comes down to it, active versus passive investing is fairly straightforward.
It ultimately comes down to fees, the ability to manage taxes, and potentially the regions you’re investing in. What’s most important as an investor is to focus on the things you can control. This includes how you react to portfolio gains and losses, saving and spending habits, and aligning your money with specific goals.
If you need a portfolio review, financial plan, or want to debate active versus passive investing, schedule a free consultation today!
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Co-Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!