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Trending far greater than matcha, pressed-juice cleanses, and kale are index mutual funds and ETFs. In 2016, close to $430 billion (that’s billion with a b) of investor money was used to purchase U.S. index-tracking funds alone, turning up the heat on a long-standing debate about which investment style is better: passive index investing or active management? The terms “passive” and “active” refer to a style of investment management. As the name suggests, there is more activity in an active strategy, compared to a passive approach. But, what does that mean, exactly, and which style is superior?
Passive: Electing a passive investment strategy would be like hiring a personal chef that offered selections based on a pre-set list of ingredients, which rarely changes. Similarly, when choosing a passive mutual fund or ETF, the manager of the fund will purchase investments off of a pre-set menu or index. For example, the Vanguard 500 Index fund is invested in the 500 stocks that comprise the S&P 500 index and in equal weights (i.e., if Apple represents 3% of the S&P 500, then the Vanguard fund will also hold 3% of Apple). The manager is not at liberty to look for other options and will only make changes to the underlying investments when an index changes (not often). Passive management is referred to as “index investing” for this index-mimicking nature.
Active: Electing an active investment strategy, on the other hand, would be like hiring a personal chef who intends to make changes to menu items based on price and seasonality of the ingredients, as well as new ideas. An active fund manager has the flexibility to explore and make changes. He or she is not confined to a pre-set list or index and can choose or alter the underlying investments when deemed appropriate.
Which style is better? Both investment styles have their merits and the debate continues about which approach is better. Some eight years into a bull market since the last low in March 2009, active managers caution that the record flow of funds to passive strategies demonstrates a herd-like mentality and encourages buying investments at high prices. Contrarily, passive managers have long asserted that active managers have been unable to justify their higher fees. Just as there is no guarantee you’ll actually like the active chef’s new menu items, there is no guarantee that an active manager will perform better than a passive one. In reality, there will be times when passive strategies perform better than their active counterparts and other times when they will not.
Rather than make a definitive claim where we cannot, we will acknowledge that there may be room for both in your portfolio and provide a couple of key considerations to help you decide:
Cost: Due to the additional time and research it takes to seek out other ideas, active fund costs are higher when compared to passive alternatives. The average active mutual fund expense is between .65%-1.3%, compared to .10%-.40% on passive funds and .5% on ETFs. The question of cost becomes one of preference and expectation: which style makes you feel more comfortable in the current market environment, or, do you believe that the autonomy of an active manager is worth the additional expense?
Behavior: Index funds and ETFs are typically market cap weighted and, as a result, the stocks and industries that perform well become an ever-larger portion of the index and the funds tracking it (think back to the “dotcom” bubble in the 1990s, at the end of which technology accounted for over 55% of the Russell 1000 Growth Index). As a result, passive products tend to do best in momentum-driven markets. Alternatively, active managers maintain the flexibility to reduce the weight of a particular investment if he or she has reason to believe momentum will not continue.