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For some fortunate people, personal chefs are as customary as turkey sandwiches on Black Friday. For most of us, however, a professionally-commanded kitchen is out of our financial reach. While we can’t make the case for fitting a Curtis Stone into your budget, we can use a personal chef to help you understand two of the most common investment terms: “passive” and “active.” 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?
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 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 (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 also referred to as “index investing” for its 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 the menu items based on price and seasonality of the ingredients, as well as new ideas. Just as an active chef has the liberty to explore and make changes, so too does an active mutual fund manager. He or she is not confined to a pre-set list or index and can make changes to 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. Just as there is no guarantee you’ll actually like the active chef’s new menu items, there is no guarantee an active manager will perform better than a passive one. In reality, some active strategies are better than passive strategies, and others are not. So, rather than make a definitive claim where we cannot, we will provide a couple of key considerations, instead:
Cost: Due to the additional time and research it takes to seek out other ideas, active fund costs are higher when compared to their passive counterparts. 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 expectation: can you expect the autonomy of an active manager to be 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.