Know Your Funds: Passive vs. Active Management

When deciding how to invest your money, you face an overwhelming number of options. It seems that every day there is a new trend being pitched as the “silver bullet” road to riches, and “expert” opinions are in no short supply.

However, data speaks louder than words, and there is enough research to show that trends eventually fail. This is why any financial advisor worth their salt will preach diversification through proper asset allocation— which means spreading your investments into various parts of the market so that all your investment “eggs” are not in one basket.

This concept sounds simple enough, but nothing in the financial industry can go without debate. There are hundreds of ways a person can choose to spread out their wealth, but in general your investments can be divided into just two categories:

  • Individual entities (i.e. directly holding Facebook or McDonalds stock)
  • Investment Funds like Mutual Funds and ETFs


Benefits of Investment Funds

One of the biggest risks you face as an investor is having too much exposure to a single company. History has shown that even the most stable companies can go under in a moment’s notice, and the last thing you want is to be caught with all of your money tied up in that company’s stock.

This principle also applies to sectors of the market. It is very possible that the US stock market could be having a bad year, but companies overseas are doing very well. This being said, a prudent investor will make sure they spread their funds over a broad range of companies in various sizes and markets throughout the world.

But how does one person manage to pick enough companies to sufficiently diversify their investments?

That’s where investment funds come in. Mutual Funds and ETFs offer an efficient way to get broad exposure to various segments of the market, taking a lot of weight off of the individual investor.


Introduction to Mutual Funds and ETFs

The two most common types of investment vehicles are Mutual Funds and Exchange Traded Funds (ETFs). Both work similarly, but have minor differences. In this article, however, we won’t dive into the technical differences between mutual funds and ETFs.

Each fund (ETF or mutual fund) is a collection of individual stocks, bonds or a mix of both. Investors who buy into the fund effectively get a partial share of every company that the fund owns. They don’t actually own each company, but they get exposure to the market movements of each business.

An Example

  • Let’s say a mutual fund owns equal dollar amounts of Apple, Amazon, Facebook, Netflix, and Google. At the time of this article, just one share of each of these companies would cost over $3,700.
  • For someone who is just starting to invest, it may be cost-prohibitive to buy stock in the companies they believe in. However, you may be able to buy a fund that owns these stocks for only $25 per share. This allows you to have exposure to the companies you care about without the expense of buying whole shares.

The example above only uses five companies, but, in reality, mutual funds and ETFs can include hundreds of stocks and bonds, offering a unique opportunity to get exposure to large portions of the market in a very cost-efficient way.

Most funds will focus on one portion of the market. For instance, there could be a U.S. Technology ETF that contains the 100 largest tech companies in America. Or an “emerging markets” Mutual Fund may own the stock of 450 companies in small or developing countries around the world. These funds can be as specific or as diverse as they want to be — and there are thousands of them to choose from — so you need a well-thought-out investment plan in order to choose the right funds for you.


Passively-Managed (Index Funds) Vs. Actively-Managed Funds

Within mutual funds and ETFs there are two prominent categories: actively- and passively-managed funds.

Actively-Managed Funds
In an actively-managed fund, there is a fund manager who works with a team of people to physically pick which companies will be included in the fund. This can be done many different ways, including the use of computer programs and algorithms or by using the sole discretion of the management team. Either way, there is a human element that goes into picking and maintaining the funds in the account.

Passively-Managed Funds (Like an Index Fund)
On the other hand, a passively-managed fund is set up to mirror a segment of the market and use no discretion from a human management team. The most popular type of passive fund is called an index fund.

An index fund holds the same stocks, in the same weighting, as a known market index.

An Example

  • The S&P 500 is an index of the 500 largest companies in America. An S&P 500 index fund, would hold all of the companies in the S&P 500 in the same weight as the index. Because they are tracking an existing index, these funds take very little management and are, therefore, normally cheaper than actively-managed funds.

There are arguments for and against each type of fund, with proponents of active management claiming that their managers are able to study the companies within their fund and make proactive changes. Supporters of index investing state that humans are historically very bad at predicting markets and picking stocks, so a passive approach is the more logical choice.


The Research

Studies have shown that, over time, an overwhelming number of actively-managed funds underperform the index that they are intended to track. In fact, according to the SPIVA 2018 Year End Scorecard, 85% of active managers of US Large Cap equity funds underperformed the S&P 500 over a 10-year period.

This discrepancy is not limited to the US markets. The same study shows that active managers in the International Equity and Fixed Income markets underperformed their benchmarks by 81% and 80%, respectively.

A common argument for active management is that the human intervention is able to soften the blow in down markets. This may be true on a short term basis, but it is far more important to maintain a long-term view on your investment strategy. Historically, index funds have provided higher returns with less expense, making them the logical choice for our InvestRx models.

Another argument for active management is that, in markets where research and data may not be readily available, it pays to have an expert manager picking the companies in the fund. This is an area where many advisors do see value, and the reason many will choose actively managed emerging markets, fixed income and sector funds.


How We Choose to Invest at InvestRx

Considering all of the data mentioned above, we have chosen to use a blended approach to the funds we select for our models. For our US and international equity funds, we use exclusively indexed mutual funds. The low cost, coupled with the simplicity and transparency of index funds, made them the logical choice since the US markets are well-documented and extremely efficient.

Since we believe strongly in having exposure to the technology, healthcare and infrastructure sectors, we chose to use actively managed funds that focus in these areas. We have also elected to go with active managers in a few of our fixed income funds. We believe that the added cost of active management is paid for by the expertise of the individuals running these funds.

We chose to use mainly Fidelity funds because of their consistent track record and extremely low internal expenses, which allows us to reduce the total cost to invest for our clients.

Do you have questions? Contact our team of advisors and we’ll be in touch shortly.