Passive investing has become increasingly popular in recent years. Do active funds still have a role in your portfolio?
To understand passive investing, we need to understand the concept of indexing. An index is created by an investment research firm (such as S&P Global) that defines the criteria for what securities (stocks or bonds) are included in the index.
In the case of the S&P 500, it is 500 US-based companies who meet various requirements related to their market capitalization (size), earnings and trading volume, among other things. The criteria is laid out clearly and the composition of the index is reevaluated and updated on a regularly scheduled basis (such as quarterly). It is a fairly objective process that doesn’t involve emotions or opinions.
Since you can’t directly invest in an index (it is essentially a measurement), investment companies have created funds that hold the securities included in the index. This gives investors a simple way to invest in the index, where they would otherwise need to individually purchase all of the underlying holdings. This is why a fund that is constructed through an objective set of criteria that requires very little human decision or opinion is considered a passive investment.
Index (Passive) funds are typically…
- Tax-efficient – The composition of most indexes changes slowly over time, so these funds typically have a low amount of trading and turnover.
- Low-cost – The low-touch, passive investment style naturally creates lower expenses.
- Helps remove emotions – Buying an index is much different psychologically than choosing a manager, management style or particular active fund.
In contrast, an active fund manager needs to make a lot of decisions about which securities to invest in and how to time the buying and selling to generate returns for investors. It’s this discretionary ability that is at the heart of what is expected of an active manager or fund. There can be sectors of the market where active management makes a lot of sense due to the ability of the manager to navigate difficult or changing environments.
When compared to index funds, active funds are typically…
- Less tax-efficient – The increased turnover typically creates more taxes due. The investor doesn’t have any control over the amount or timing of taxable events. This can be mitigated by the type of account where the fund is held.
- Higher cost – The expenses related to the managers, analysts and increased complexity create a headwind for the investor which needs to be overcome by increased returns. On the other hand, this is the whole point of an active fund and you will need to decide if the cost is worth the potential benefit.
So which one is right for me?
The most recent data shows that the overwhelming majority of active managers consistently underperform the indexes. It is becoming increasingly hard to beat the index. When you add in the lower expenses and greater tax-efficiency, you can see why The Money Guy is a strong advocate for passive, index investing. But the decision shouldn’t be seen as all or nothing. When used intelligently within your portfolio, we still believe there can be value in the discretionary management provided by active funds in certain market sectors.
Check out the video below for more information about index investing.
