After you’ve chosen a great online broker, added some money to your account, and decided your own risk tolerance, the next step is typically to decide between an active vs. passive investing approach.
As you’ll quickly find out, the active vs. passive debate can feel as polarized as politics, with some financial experts swearing you need to buy shares in active mutual funds and others telling you to put your money in index funds that simply follow the market’s ups and downs.
So, as a beginner investor, or someone with a little experience under their belt, which approach is right for you? Let’s take a closer look at the passive vs. active debate and see.
What is the difference between active and passive investing?
First off, when you hear people talking about active vs. passive investing, they’re typically referring to how investment funds, such as mutual funds or index funds, are managed. Recall that a fund is simply a basket of investments (usually stocks, but also bonds). When you buy a share in a fund, you instantly diversify your portfolio, as a fund holds numerous stocks.
When a fund is actively managed, the fund manager is trying to outperform an index market, such as the TSX. These fund managers are nearly always financial experts who have the credentials and qualifications to choose a fund’s stocks.
The promise of an actively managed fund is that over time your portfolio will have a higher return on investment (ROI) than the index market itself. Most mutual funds involve an active investing management.
A passively managed fund, on the other hand, doesn’t try to beat the market. Managers of passive funds, such as index funds or exchange-traded funds (ETFs), simply want to match the performance of a specific index. For this reason, passive funds can mirror the ROI of the index markets they follow, but they’ll never surpass it.
Because passively managed funds follow the ups and downs of the market, they typically require far less human oversight. Most are automated, which helps keep the costs of passively managed funds fairly low. Active funds, on the other hand, require far more work on the part of the fund manager, which is why their fees are higher.
Do active funds outperform passive funds?
You’d think actively managed funds would almost always outperform passive ones, right? After all, an active fund manager can react quickly to market downturns, sell shares of bullish stocks before they turn bearish, and find undervalued stocks faster than a robot. How could you beat that?
In reality, active fund managers rarely outperform passive funds over the long-term. It’s not hard to imagine why. Picking stocks that beat the market, not just once, but numerous times, is extremely hard to do. Even if you have a great fund manager, there’s absolutely no guarantee that their choices will have a higher ROI than the market itself.
Aside from human error, there’s another reason passive funds typically outperform active ones over the long-term: fees. Actively managed funds simply cost more than their passive counterparts. The management expense ratios on active funds can cost on average 1.38% more than passive funds.(1) When you’re trying to beat the market, that 1.38% can easily drag you down.
For this reason, many Canadians are starting to follow the world trend of choosing passive vs. active investing. Passive funds don’t beat the markets they follow, sure. But, over the long term, their ROI mirrors its performance. The fees are lower, ensuring you get the full benefit of your returns.
What are the pros and cons of active investing?
Perhaps the biggest advantage of an active investing approach is having a human investor on your side. Active fund managers are usually surrounded by teams of financial experts and analysts who spend their days conducting in-depth research to pick the right stocks and identify lucrative opportunities. When these fund managers are right in their choices, you could hit it big.
Of course, the obvious downside is that active fund managers can’t guarantee they’ll beat the market. Nobody can guarantee that. If you buy shares in an active fund under the assumption that you’ll earn significantly more than the market, you might be disappointed when your returns are meagre, or worse — less than the market’s average ROI.
Then there’s the fees. Because you’re getting a team of experts, you’ll pay higher MERs to hold shares in an active fund. That means, your fund will have to not only outperform the market, but earn you more gains than the fees themselves.
Again, if your fund manager has the skills to create a market-beating portfolio, the fees might be worth the lucrative gains. Just don’t go into an active fund thinking you’ll automatically get higher returns than the market. Over the long-run, it’s extremely difficult for a fund manager to beat the market every time. It’s not impossible. But you’ll want to be prudent in your choice of active funds.
What are the pros and cons of passive investing?
Passive investors pay far less in MERs than their active counterparts. In fact, according to one study, the average MER for a passive fund in Canada is around .28%. For active funds, the average MER jumps up to 1.59%, resulting in a 1.31% difference.
Is 1.31% really that significant? You bet it is. As a quick example, let’s say you invested $10,000 in an active fund with a MER of 1.59% and another $10,000 in a passive fund with a MER of .28%. Let’s also say both funds had a 5% average rate of return for the first year, which is around $500 for each fund. In the passive fund, you’ll end up paying .28% of $10,500, or around $29.40. For the active fund, you’ll pay $166.95 for the same gain. That’s more than five times the passive fund’s fees!
In addition to low MERs, passive funds are beneficial in that they mirror a market’s performance over long periods of time. When the market goes up, so do your shares. Of course, when the market goes down, you’ll lose money in the fund. But if your index follows a general upward trend over the long haul, your share’s ending value can be fairly high.
Active vs. passive investing: which is better for you?
If you don’t have time to research your own stocks, or you are just starting to invest, a passive investing approach may be right for you. You won’t pay high MERs, and you can rest assured that your investments aren’t straggling far behind the market. On top of that, passive funds give you instant exposure to a wide variety of companies within a specific sector or industry, helping you diversify your portfolio at a fairly low cost.
Of course, you don’t have to choose a side in the passive vs. active investing debate. You can buy shares of both. In fact, many investors have been successful at combining passive and active investing strategies. In this way, a passive fund can give you greater security, while an active fund can put a little edge on your investment portfolio.
Before you choose an active fund, be sure you do your research first. Some active funds cost far less in MERs, while others will have fund managers with a proven track record of outperforming the market.
The goal is to find an active fund manager who has consistently outperformed the market over a long period of time, while also doesn’t charge higher MERs than their peers. Combine that with a passive fund that follows a strong market index and you could have a well-diversified portfolio on your hands.