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Among mutual funds and exchange traded funds (ETFs), there are a number of varying objectives from which to choose. While cost is important to know and consider, it’s only one of a number of factors that makes up the whole of a trading strategy. At a high level, two different management types exist: passive and active. Our purpose here is to examine the differences of active versus passive management, determining when it makes sense to choose one over the other.

Passive Funds

Passively managed funds are constructed in order to imitate the movement of a specific index. A market index is a hypothetical portfolio of investments which is used to track the overall performance of the stock market or certain subgroups of it. For example, the S&P 500 is an index which tracks 500 publicly traded companies that represent some of the leading companies in the US economy. The Dow Jones tracks 30 large, publicly traded companies that are considered to have high quality products and services along with relatively stable historical earnings.

While an index is not something which can be purchased directly, it can be closely imitated by a fund which is managed in order to replicate its makeup and performance as closely as possible. The decisions to be made in an index-tracking fund are relatively minor and usually technical in nature, rather than attempting to predict future market movement. Because of this relatively small effort by the fund managers to keep the fund tracking its index, the costs of passive index funds tends to be cheaper than that of an actively managed fund.

Active Funds

Actively managed funds have an objective different from passive: they are not interested in simply matching an index’s returns. They are interested in another objective, of which there can be a variety.

Some may aim to beat a particular index (their benchmark) on average over a period of so many years. Some may aim to average a specific rate of return. Some may have the objective to preserve capital while capturing a small amount of interest. Some might have the purpose of creating high income, either through interest or dividends, with very little focus on growth of the underlying assets. And some might have the objective of growth, but without the inclusion of certain sectors or companies which some may not want to support due to ethical reasons. If there is a goal to be desired, it is likely that a mutual fund exists with that objective in mind.

Because active funds require a good deal more time, research and professional insight from the managers, understandably they will generally come with a higher fee than a passive fund.

Passive or Active: Which is Better?

As with most things finance, the answer here depends on what you intend as an investor. No one knows the future, and no one is going to be able to predict the future accurately all the time. What this means is that if you’re purely interested in the absolute return of a fund, then you’re going to need to define what that goal is and make sure it is supported by a solid “why.”

The reason being that, in an extreme case, if someone is looking to double their money in a year, the likelihood of this happening regardless of their investment strategy is close to zero. If they attempt such radical growth, it is almost just as likely that they could lose a massive part of their investment over that same time period. So that is why a goal must be defined; it’s not as simple as wanting to make as much as possible over the next year. If that’s someone’s goal, then they’re probably better off focusing on their power to earn rather than to invest.

But if the goal is more reasonable, say for example, to beat the S&P 500 on an average annual basis over the next five years, then this gives us a clearer idea of what might be appropriate. Again, no manager, regardless of experience, is going to consistently beat a benchmark every single year or over every timeframe. But depending on one’s “why” behind beating the benchmark, we can determine the importance of meeting this objective and the risks involved with not meeting it. Then we can balance the risk of failure with the potential reward of success, and calculate if this is a fair tradeoff.

Keep in mind that most active managers that seek to beat a benchmark have been unable to do so over long periods of time. At the same time, there are a select few who have defied the odds and done so.

But looking across the broad spectrum of fund managers, the odds are against the investor who sets out to beat a benchmark. The reason for this is that stock markets are efficient; different investment professionals may argue about just how efficient they are, and whether there are any exceptions.

What that means is that markets reflect all public knowledge about any company or world event, and take into consideration the probabilities of success or failure in the future. That means the only way that a fund manager can “beat” the market is either by luck (a broken clock is right twice a day) or by a near genius ability to put data together in such a way that gives them insight beyond what most people are able to deduce from public information. 

And in the completion of this intense research, the fund managers of course need to be paid through fees charged from the fund, making it even more difficult to beat their benchmark net of fees.

But active managers have an incentive to beat the markets. The investor’s success is also their success, because the larger they can grow their fund, the greater the dollar value of the percent they charge in fees for their services.

Here are a few questions you can ask yourself to determine which strategy might be right for you:

• Is it worth the fee to know that you have a human making informed decisions and who also wants your fund to succeed in its objective?
• Are you interested in something other than just absolute return?For example, are you interested in generating interest or dividends specifically? Are you more interested in a smoother ride (less volatility) than in the potential upside? Would you rather your investments go toward a cause, such as sustainability, or avoid certain industries such as alcohol?
• Are you satisfied with “average” returns of an index fund?
• If you are willing to take on the added risk involved with attempting to beat a benchmark, then what is the plan if your fund has underperformed the benchmark in the years ahead? If the answer is to change funds, then how will you evaluate the next fund in a different way than you evaluated the first one?

Conclusion

As with most strategies in finance, there is not an all-encompassing right or wrong answer to the question, because investments always involve risk and uncertainty which has to be balanced with one’s objectives, as well as willingness and ability to take on the risk.

Remember that it is always important to know your “why.” This can help be your guide, because there will inevitably be times when things don’t go your way. Markets will go through large downturns (bear markets), and will more regularly go through pullbacks (down 5-10%) and corrections (down 10-20%), which can often be sharp and scary. The importance of having confidence in your strategy, and the power of long-term averages and compounding, cannot be overstated.

Investors can tend to be their own worst enemy, making too many changes too often because of performance, or because of a news article that makes things look like they will never be the same. This is normal and constant, and the temptation must be avoided to try to time markets if an investor expects to be a long-term success.

As the famous British investor Sir John Templeton said, “The four most expensive words in the English language are, ‘This time it’s different.’”

Choosing active versus passive management is one thing. Choosing a specific fund or funds is another. And beyond that, staying consistent and disciplined is entirely another.

When it comes to investing, knowing just enough to be dangerous is a real thing. Investors often don’t understand the vast extent of the wealth they give up during their lives because of their fear of loss as well as their overconfidence in their ability to predict. A financial advisor can be a valuable partner in helping not only choose a strategy, but to make informed decisions of when to stick with the strategy and when it truly is time to make a change.

Use what we’ve learned here as a guide to help you choose the proper management style for your goals and objectives. If you’re interested to learn more about how to determine the proper risk structure for your situation, check out Asset Allocation: Are You Getting Your Best Return?