Over the past few years, investors have seen a groundswell of support around “passive” investments, which have been touted by Warren Buffett, major institutions like Fidelity and many other prominent voices in the financial industry. Passively managed mutual funds or exchange-traded funds (ETFs) are promoted as low-cost investments with relatively little volatility, and investors may see them as a perfect investment.
Before deciding where to invest your hard-earned money, it is important to know the differences between passive funds and active funds, along with the pros and cons of each investment route.
Understanding passive vs. active management
The term “passive fund” is used to describe an investment strategy that tracks a market index or portfolio. Passively managed funds are sold by investment management companies, like The Vanguard Group, Fidelity and BlackRock, but are designed to follow the market performance of the fund’s target index.
On the other hand, “active funds” are guided by managers who pick the securities and strategies used in the fund’s portfolio. The goal of an actively managed fund is to generate a higher return than the market by utilizing analytical research and investment experience to create a winning portfolio. While active funds may follow a specific market index, managers will take steps to minimize risk and maximize profits, using strategies like limiting exposure to securities with poor performance, short-selling and derivatives trading.
Passive funds are often touted as low-risk investments into which investors can place their money without worrying about major losses. While passive funds, like index funds, typically have lower volatility than stocks, their “risk” can vary greatly based upon the market segment they are following.
As an example, using the fund made to mirror the performance of the 500 companies that make up the S&P 500 index, it would take a major shift in the overall market for its value to change significantly. However, a fund in the technology sector, which mirrors the performance of IT companies including Apple and Microsoft, will be more influenced by the ebb and flow of a smaller number of companies in the technology sector, potentially exposing the investor to greater losses. When considering a passively managed fund, it is important to research the securities it holds and the risk associated with its composition.
While there is no guarantee that actively managed funds will perform better than passive funds, some investors feel more confident buying financial products that they know are being guided by a human manager, instead of a computer algorithm.
Each fund charges its investors a percentage of its total value, or an “expense ratio,” as a cost for owning a share of the fund. Active funds typically have a higher expense ratio than passive funds, since managers are directing the fund’s composition on a day-to-day basis. For example, Morningstar found that the average asset-weighted expense ratio for active funds was 0.79%, compared to 0.20% for passive funds. When choosing between a passive and an active fund, investors should consider whether they believe the active fund can consistently outperform the market at a level that makes the higher expense ratio worthwhile.
While some investors might assume that passive funds cost less than active funds, it is important to read the fund’s prospectus to fully understand the terms of investment. Investors should also make sure to consider expenses like sales charges and taxes that could be associated with the sale of shares.
Looking at the bigger picture
When planning for your financial future, it is important to look beyond the securities in your portfolio and consider your broader financial goals, and how your actions today will impact them. While anyone can invest in a passive index fund, doing so is not a magic bullet for all financial situations. Consulting a financial advisor or visiting a website such as www.investopedia.com can offer valuable insights in helping you determine if investing in passive funds is a smart approach for you.
*All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance does not guarantee future results.
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