Understanding investing can be intimidating for those who are learning to start investing. One of the many decisions new investors will need to make is deciding between actively managed funds and passive funds.
What is a passive fund?
Passively managed funds are those where the objective of the fund is simply to have returns in line with the overall market returns. As such, passive funds do not seek to “beat the market.” Rather, they try to “match the market”.
This goal is accomplished by buying all of the stocks represented by an index.
For example, the S&P 500 tracks the progress of the 500 large publicly traded companies. If you were to buy an S&P 500 index fund, you would now own shares in those same 500 companies. When the S&P 500 goes up then your fund will go up. But, your fund will not go up by more than the S&P 500.
What is an active fund?
Actively managed funds have the objective of beating the market. As such, active fund managers seek out companies that they believe (based on an unbelievable number of indicators) will outperform their peers. Let’s say you had a mutual fund that invested mostly in larger companies. It is possible that your fund will do better than the S&P 500, but it is also possible that your fund will do worse than the S&P 500.
Which is better? Passive Funds or Actively Managed Funds?
I’ll let you know from the start that I do invest both types of funds, but more of my investments are in actively managed funds. However, if I could go back 10+ years when I first started investing for retirement, I would probably lean more towards passive or index funds.
Why?
Actively Managed Fund Fees
For the privilege of picking stocks that may or may not perform at or above the market, I had to pay a royalty for that privilege. I’m feeling too lazy go back and look at 10+ years of statements, so I’m going to make some observations from my gut rather than my calculator. For a period of about seven years, each and every time I purchased a fund, I would pay 5% in a front end load fee. Today I’d take a passive fund with an automatic 5% head start instead of an active fund. I wasn’t comfortable handling my own investing until I discovered the Sound Mind Investing Newsletter.
However, there are active funds that do not charge load fees. Still, you will pay more in fees when you have an actively managed fund (you do need to pay that legion of workers who are trying to help your investment grow).
The Passive in Passive is Appealing
Though index fund investors do still make very important investing decisions – like asset allocation, investing in passive funds is simpler. You don’t need to read reports. You don’t need to evaluate company strengths. You don’t need to attempt to pick a winner. You simply buy the index fund for the part of the market where you want to put your investments.
How about a little of both?
I currently invest in both types of funds. I think that helps me have a balance of conservative and aggressive. It lets me take some extra investing risk without unduly risking my investment. The most important thing is to develop an investing plan and stick with your plan.
Do you prefer active or passive funds? Why?
Photo by BlatantNews.com.
{ 2 comments… read them below or add one }
you are right that passive funds track/mimic an index but not all indexes are meant to track the market. thus passive funds can be used to track sectors and asset classes. they are typically very low cost.
also there is ample evidence that the majority of actively managed funds do worse than their indexes. on average 65% actively managed funds do worse than their index standard and this is even before taking into account the higher expense ratios and extra taxes you will pay for the higher turnover in those funds relative to passive index funds (low turnover and therefore lower capital gains that are taxable). the frequent counterpoint is “well i will find the active manager who has beaten their index the last 10 years”. however, there is little to no proof that such a manager can duplicate their feat (ie. past performance does not guarantee future success). thus, are you willing to take a 35% gamble that the manager/fund you choose will beat the index and take the guaranteed hit/loss of the load or higher expense ratio for that “hope” that they will be in the top 35%? most people call this a loser’s bet and it is how casinos have made millions off hapless folks who take similar losers’ bets on their parlor games.
I always go for passive funds. As the commenter above says how are you supposed to know whether the fund manager will be above or below the index? Past performance means nothing – they might just have been lucky. And as the stats show there is a much higher chance that the manger will be below the index than above it.
You might as well accept that fund managers aren’t worth the extra cost and go for a passive fund. With a passive fund you piggy back onto the collective wisdom of all the fund managers out there, and are likely to outperform any of their funds when you take the lower costs into account.