The Great Debate: Active Versus Passive Funds

At the forefront of the investment world over the past decade has been the debate over active and passive investing. Active funds, or mutual funds, have managers that actively buy and sell investments 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 my personal investment philosophy is geared towards the passive side, there can be a role that active funds play in a portfolio, too. Understanding the difference between active and passive funds is crucial to properly managing your portfolio.

Active Funds Versus Passive Funds

First, let’s compare what actually qualifies as an active fund and what qualifies as a passive fund. 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. (For more, see: Passively Managed vs. Actively Managed Mutual Funds: Which is Better?)

Passive funds include index funds and ETFs, both of which don’t have managers that are attempting to beat their benchmark. 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. 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. This is a much more difficult goal to accomplish, as there are no guarantees when it comes to timing the market.

Comparing Fees

Fees are what hold back active managers from beating their benchmarks. 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 five 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.

The 2017 SPIVA report card 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 failed to beat the S&P 500. This is resounding evidence to be careful when selecting actively-managed funds and to be sensitive to the fees you pay for your investments.

Tax Efficiency

Managing taxes can have a big impact on returns for investors. Another primary difference between mutual funds and index funds and ETFs is 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. (For more, see: Active Management: Is it Working for You?)

Index funds and ETFs, 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.

Be aware that 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

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 that 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

Despite the negative explanations of active funds given thus far, there are 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

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. (For more from this author, see: Understand Risk Before You Diversify.)