1. Exchange-Traded Funds: Introduction
  2. Exchange-Traded Funds: Background
  3. Exchange-Traded Funds: Features
  4. Exchange-Traded Funds: Biggest ETFs and ETF Providers
  5. Exchange-Traded Funds: Active Vs. Passive Investing
  6. Exchange-Traded Funds: Index Funds Vs. ETFs
  7. Exchange-Traded Funds: Equity ETFs
  8. Exchange-Traded Funds: Fixed-Income and Asset-Allocation ETFs
  9. Exchange-Traded Funds: ETF Alternative Investments
  10. Exchange-Traded Funds: ETF Investment Strategies
  11. Exchange-Traded Funds: Best Practices for Trading ETFs
  12. Exchange-Traded Funds: Conclusion

The phenomenal growth of ETFs in this Millennium has intensified the debate about the relative merits of active versus passive investing. Active investing is losing ground – according to a Bloomberg article, flows out of active and into passive funds reached nearly $500 billion in the first half of 2017. While passive funds accounted for a third of total AUM in the U.S.as of July 2017, compared with about a fifth a decade ago, active-management funds still have $10 trillion invested in them. But passive funds are catching up, with global ETF assets forecast to exceed $7 trillion by 2021. So what are the pros and cons of these two investing strategies that are at polar opposites? (Related: Active vs. Passive Investing)

Active Investing

Active investing attempts to outperform or beat the market, which is represented by an index or benchmark. The majority of mutual funds are actively managed. Fund managers spend a great deal of time and money in researching and analyzing market trends, the economy and companies in order to obtain timely information and gather unique insights.

The objective of this exhaustive research and analysis is to gain a competitive edge in making sound investment decisions that will enable their investments to outperform the benchmark. Active managers believe that because markets are inefficient, anomalies and irregularities in capital markets can be exploited by those with skill and insight. In their view, prices react to information slowly, allowing skilful investors to systematically outperform the market. (Related: A Closer Look at Passive Vs. Active Management)

Passive Investing

Passive management or indexing is based on investing in exactly the same securities and in the same proportions as an index like the S&P 500 or Dow Jones Industrial Average. Vanguard founder John C. Bogle created the first index fund in 1975 after concluding that the actual performance of active mutual funds would be worse than that of comparable index funds because of the higher fees charged by active managers.

Index fund managers do not make decisions about which securities to buy or sell within an index; they merely follow the same methodology of constructing a portfolio that is used by the index. The goal of passive management or investing is not to beat the market, but to replicate the performance of an index as closely as possible.

Passive investors believe in the Efficient Market Hypotheses (EMH), which states that market prices are always fair and quickly reflect all available information. EMH adherents believe that it is difficult to outperform the market on a consistent basis.

Recent Evidence

Since 2002, S&P Dow Jones Indices has been publishing the SPIVA Scorecard, which it bills as the de facto scorekeeper of the active versus passive debate. The mid-2016 Scorecard showed that about 90 percent of active stock managers failed to beat their index targets over the previous one-year, five-year and 10-year periods. The year-end 2016 Scorecard revealed that over the 15-year period ending December 2016, 92.15% of large-cap, 95.4% of mid-cap and 93.21% of small-cap managers trailed their respective benchmarks. Over the same 15-year period, large-cap value managers fared better than their growth counterparts.

Active vs. Passive: Pros and Cons

The main advantage of active management is the possibility that the fund manager may be able to outperform the index due to superior skill at picking stocks or securities that will outperform. An active manager can also be extremely selective about the securities in which to invest, rather than being forced to buy the good and bad stocks alike that make up an index. If the fund manager believes that the market may tend lower and perhaps decline sharply, he or she has the leeway to take defensive measures such as hedging the portfolio and/or increasing cash positions to act as a buffer against the expected rise in market volatility.

The biggest disadvantage of active investing is that it is more expensive, resulting in higher operating expenses and hence fees that are paid by the investor. Higher fees are a major impediment in the quest to outperform consistently over the long term. In the SPIVA Scorecard referenced earlier, a significant part of active managers’ underperformance could be attributed to their higher fees. Active managers also tend to run more concentrated portfolios, with fewer securities compared to broad market indices, which can result in massive underperformance if they make the wrong calls.

The main advantage of passive investing is that it closely matches performance of the target index. It requires little decision-making by the manager, which translates into considerable savings on the research and analysis required for active management. This results in significantly lower operating expenses and hence lower fees to the investor.

The drawback of passive management is that there is no possibility of outperforming the underlying index. Managers are unable to take action if they believe the overall market will decline or if individual securities should be sold.

Investors who held index funds over the course of the 2000-02 and 2007-09 bear markets would have witnessed these funds plunging by 40% to 50% from peak to trough. But notwithstanding those massive declines, the SPDR S&P 500 ETF Trust (SPY) has still returned 9.45% annually since its launch in January 1993.

Exchange-Traded Funds: Index Funds Vs. ETFs
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