Passive Index Funds vs Active Management Funds
by Philip Tull | September 15, 2017 | Financial Planning
Have you ever thought about how you make your choices every day? Take traffic, for instance. My brother lives in Washington, D.C., and works roughly an hour away from where he lives. On any given day there could be traffic that extends his drive 30-40minutes, or even more! Because of the traffic the shortest route is not always the fastest; but if you were to take that route every time, you may make the trip in an hour 50% of the time, but the other 50% of the time – well, I hope you brought some good podcasts to listen to. So each day my brother takes an active approach and surveys Google maps to see what traffic looks like, and what alternate paths he can take to beat the rush. With this system he often beats the traffic, though at times he may not. It is a choice he must make.
What does this have to do with my finances, you ask? In many ways, active management (choosing the calculated best route) vs passive indexing (shortest on average route) is like his daily commute. Whether you are choosing a fund lineup for your company retirement plan or opening an investment account for the first time, you likely chose either passive index or active managed funds. Have you ever wondered which choice was best? The answer is…both!
Over the last 3-5 years it has been highly debated whether passive indexing or active management is a better strategy. The overall findings have yielded that the two strategies have a cyclical relationship. History has shown that over the past 30 years they have nearly equally outperformed each other annually. There is no clear winner. Often when indexes perform well, active managers underperform and vice versa. One factor that has shown to be consistent is, that during bear (down) markets, active managers often outperform the index.
Now for the pros and cons. Unlike index funds, active managers have the flexibility to add and remove any position, allowing them to select stocks they believe are optimal performers, or remove stocks that are positioned to underperform any given market segment or period of time. Index funds must hold the companies within their specified index. Not choosing the positions within the fund allows for lower costs, but also forces the fund performance to be at the mercy of any underperformers dragging the overall return. Low-cost fees are one of the most advantageous factors of passive investment strategies. With the average index fund only charging .20-.50% annually, active managers must work hard to earn their fees of upward of 1%, though many do just that.
So how do you choose? Here’s a guideline: If you consider yourself a bit more market savvy and are looking to capitalize on a specific market segment and/or want to limit your downside risk, active management funds may be right for you! If you do not have confidence in your investment selection and/or want to limit your overall fee exposure, passive indexing may be right for you! If you feel you fall in-between these options, create a hybrid to include both! Thankfully, this does not have to be a tough choice…now if it was only this simple to navigate D.C. traffic.
RESOURCE: The Phrases of Finance
What is Indexing? Indexing is an investment strategy in which you invest in Mutual Fund and Exchange Traded Funds (ETF) that track or mirror an index. The indexes are composed of a selected group of companies that represent the market as a whole. The most well-known indexes:
- Dow Jones is a price-weighted index composed of 30 US companies: http://money.cnn.com/data/dow30/
- Standard and Poor 500 is a market value weighted index composed of the 500 leading US companies across all major sectors.: http://portfolios.morningstar.com/fund/index-holdings?t=SPX
- Nasdaq Composite Index is a market capitalization weighted index composed of approximately 3,000 common stocks listed on the Nasdaq stock exchange.: http://www.nasdaq.com/screening/companies-by-industry.aspx?exchange=NASDAQ
What is Active Management? Active management is an investment strategy in which you invest in a Mutual Fund or ETF that is managed by an individual or group that selects the investment they believe to show the most promise by either performing better or holding less risk than other investments. Active management funds almost always have a market sector that they specialize or focus in (e.g. large cap, small cap, growth, value, etc.).
Philip Tull recently received his Master of Financial Planning from Kansas State University, and will soon sit for the CFP® exam. He is a skilled soccer player and coach, an avid snowboarder, and a fearless fisherman. One of his goals is to make sure his Millennial peers don’t spend the rest of their lives living in basements – whether real or proverbial.
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