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.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
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.
-
Bullish IPO: Should You Buy BLSH Stock?Wall Street is buzzing about the Bullish IPO, with the Peter Thiel-backed crypto company set to start trading today, August 13, under the ticker "BLSH."
-
How the 2025 Child Tax Credit Rules Impact Single ParentsTax Credits New changes to family tax credits, like the Child Tax Credit, will impact the eligibility of some households.
-
How to Build Your Financial Legacy Three Piggy Banks at a TimeA wealth adviser shares a childhood saving technique that taught him lessons of stewardship, generosity and responsibility and helped him answer the question we all need to answer to define our lives by impact rather than greed: 'What is this all for?'
-
Which of These Four Withdrawal Strategies Is Right for You?Your retirement savings may need to last 30 years or more, so don't pick a withdrawal strategy without considering all the options. Here are four to explore.
-
July CPI Report Ignites a Risk-On Rally: Stock Market TodayMarket participants price out worst-case scenarios for tariffs and inflation and will now turn their attention to employment and growth.
-
DST Exit Strategies: An Expert Guide to What Happens When the Trust SellsUnderstanding the endgame: How Delaware statutory trust dispositions work, what investors can expect and why the exit is probably more important than the entrance.
-
Think Selling Your Home 'As Is' Means You'll Have No Worries? Think AgainThere are significant risks and legal obligations involved in selling a home 'as is' and by yourself, without a real estate agent.
-
Stocks Slip Ahead of July CPI Report: Stock Market TodayThe latest inflation updates roll in this week and Wall Street is watching to see how much of an impact tariffs are having on cost pressures.
-
What the OBBB Means for Social Security Taxes and Your Retirement: A Wealth Adviser's GuideFor Americans in lower- and middle-income tax brackets, the enhanced deduction for older people reduces taxable income, shielding most of their Social Security benefits from being taxed.
-
Financial Planner vs Investment Manager: Who's the Better Value for You?When markets are shaky, who do you trust with your money? A recent study provides useful insights into the value that different financial professionals offer.
