Investor Psychology

Active vs Passive Investing … Which Path to Take?

It comes down to fees and performance, of course, but you need to put a little more thought into the question than just that to make a good decision.

Passively managed mutual funds have been all the rage in recent years. They’ve taken market share from their active counterparts across the board, with $662 billion in inflows worldwide in 2017, according to Morningstar's 2017 Global Assets Flow Report released on May 21, 2018.

However, as with any fund or asset, investors must do more than just follow the crowd. They need to understand the differences between “passive” and “active” mutual funds so they can make informed decisions moving forward.

First, some definitions

Passively managed index funds use an algorithm to give the investor a return – positive or negative – based upon an index, minus the fee. Examples of the indexes used in passive funds include the S&P 500 index (top 500 companies in the U.S.), European stock indexes such as STOXX Europe 600, government bond indexes, etc. There are dozens of different indexes fund companies can use to construct a portfolio.

No human being is making a judgment as to the quality of the investment. For example, a computer knows that Apple makes up approximately 4% of the total value of the S&P 500 index, and your investment in the index mirrors that. Therefore, if you have $10,000 invested, you have $400 invested in Apple.

The beauty of this investment path is typically low costs, as it does not require hands-on management by an adviser. According to Investopedia, index funds typically charge around 0.25% on total investment, where a $100,000 investment would typically charge $250 per year. But such expenses often vary significantly between funds.

Actively managed funds work on the premise that experienced professionals can evaluate investment options and craft a portfolio that can strive to outperform an index. Because there is a hands-on stock picker involved, though, these types of funds typically entail greater fees. Investopedia estimates that “a good, low expense ratio is generally considered to be around 0.5%-0.75% for an actively managed portfolio, while an expense ratio greater than 1.5% is considered on the high side.” So, with a $100,000 investment, a 1% fee would amount to $1,000. In terms of how it works, while the passive indexed fund has no choice but to buy 4% of the $10,000 in Apple, the actively managed fund may decide that more or less (or none) should be invested in Apple.

The growth in investor interest in passive funds has come at the expense, to some extent, of active funds: Morningstar’s 2017 Global Asset Flows Report also estimates that U.S. investors in 2017 pumped $470 billion into passive funds even as they pulled out $175 billion from actively managed funds. Several factors are driving this, including investor desire for lower-fee products and services, as well as perceptions that actively managed funds actually underperform against the indexes. For example, according to the S&P Indices Versus Active (SPIVA) funds scorecard, over the five-year period ending Dec. 29, 2017, 84% of large-cap funds underperformed relative to the S&P 500.

That may appear to be a scathing indictment of active management, but I would suggest the active-versus-passive debate is not an all-or-none proposition – there are, after all, active funds (16%, if we go by SPIVA’s statistics) that do outperform the indices.

As with any investment decision, working with an adviser to evaluate your options and tailor a customized strategy will help you make the right decision for your circumstances.

My discussions with clients

For example, a client recently shared with me her employer’s 401(k) investment options. Conveniently, each asset category provided both a passive and active fund, but she said she planned to move all her allocations to the passive funds because they have lower fees, and she “read that is what she needs to do.” I explained, however, that the active funds her employer provided have actually been quite productive over the past five to 10 years, and maybe they have earned her business. I assured her no one can guarantee solid performance will continue, and many of the passive apostles would suggest it cannot, but long-term performance is always important to consider.

Ultimately, every investor has the choice to invest assets in both types of funds – and as with any investment strategy, diversification is key.

The moral of the story is do your homework. Be open-minded. Do not place blind faith in any strategy, and do not assume everything you read is definitive. Life, and investing, can be a little gray.

Jamie Letcher is a financial adviser of CUNA Brokerage Services Inc. member FINRA/SIPC, a registered broker-dealer and investment adviser.

The opinions expressed those of the author and do not necessarily represent the opinions of CUNA Brokerage Services Inc. or its management.

This article is provided for educational purposes only and should not be relied upon as investment advice.

About the Author

Jamie Letcher, CRPC®

Financial Adviser, LPL

Jamie Letcher is a Financial Adviser with LPL Financial, located at Summit Credit Union in Madison, Wis. Summit Credit Union is a $5 billion CU serving 176,000 members. Letcher helps members work toward achieving their financial goals and through a process that begins with a “get-to-know-you” meeting and ends with a collaborative plan, complete with action steps. He is a member of FINRA/SIPC, a registered broker-dealer and investment adviser. 

Most Popular

Are You Rich? The Answer May Surprise You
personal finance

Are You Rich? The Answer May Surprise You

Whether you are considered rich depends on how you measure it – and the bar for that is changing. Have a look at the numbers that define who's wealthy…
August 12, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
Save More on Green Home Improvements Under the Inflation Reduction Act
Tax Breaks

Save More on Green Home Improvements Under the Inflation Reduction Act

Tax credits for energy-efficient home improvements are extended and expanded by the Inflation Reduction Act.
August 19, 2022

Recommended

Tax Changes and Key Amounts for the 2022 Tax Year
tax law

Tax Changes and Key Amounts for the 2022 Tax Year

Americans are facing a long list of tax changes for the 2022 tax year. Smart taxpayers will start planning for them now.
August 19, 2022
What’s All the Fuss About Direct Indexing?
investing

What’s All the Fuss About Direct Indexing?

Investors who want control over which stocks they own are looking at direct investing. It comes with some distinct advantages, but it’s not for everyo…
August 19, 2022
10 Best Bond ETFs to Buy Now
ETFs

10 Best Bond ETFs to Buy Now

The bond market has struggled in 2022, but investors with a longer-term view should consider these bond ETFs to balance their portfolios.
August 18, 2022
7 Myths About Variable Annuities: Exposing Their Dark Side
annuities

7 Myths About Variable Annuities: Exposing Their Dark Side

On the surface, variable annuities sound almost too good to be true. But once you learn the facts about the safety of your principal, the fees and ho…
August 17, 2022