Passive, Active, or Both?
As demonstrated by the extreme market volatility in the first half of 2020, it’s very difficult to anticipate the direction of the financial markets. That’s one reason why index mutual funds and exchange-traded funds (ETFs) have drawn increasing interest from investors.
These passively managed investment funds are designed to match the performance of a particular market index by owning the same securities included in the index. The underlying concept is that rather than trying to “beat the market,” an index fund owns shares of a particular market segment. Today there are hundreds of indexes and index funds tracking various types of assets.
Trying to Pick Winners
Despite the growing interest in index funds, actively managed funds still hold more assets (see chart). However, even professional fund managers struggle to beat the market.
According to Morningstar, about 47% of active funds outperformed the average of passive funds in their category in 2019. This was a relatively strong performance and an improvement over 2018, when only 35% outperformed. The success rate over the 10-year period from 2010 to 2018 was just 23%.1
Although these statistics suggest that indexing may be the stronger approach over the long term, active and passive funds tend to perform differently over different market cycles, and they might serve a variety of purposes in your portfolio. Some analysts believe that active management may be more effective than indexing in navigating what is expected to be uneven performance of companies and industries during the economic recovery.2
Here are some pros and cons of each type of fund.
A Simple Approach
The primary appeal of index funds is cost-efficient simplicity. Because these funds have less managerial involvement, fees are often lower than they are for actively managed funds. Index funds may also buy and sell assets less frequently, and lower turnover may help reduce capital gains distributions. Tax efficiency could be an important consideration when funds are owned in taxable accounts.
The simplicity of index funds can be both a positive and a negative. Many of the well-known, third-party indexes that are commonly tracked by index funds are broad based and capitalization weighted. Thus, index investing traditionally involves buying all the securities in a market or market sector and weighting them based on their value in the marketplace. While this is a good way to capture a selected part of the market, it places heavy emphasis on a relatively small number of large companies in the index. At the same time, an index fund must hold all the securities in the index regardless of the potential performance of an individual company.
Active fund managers strive to outperform benchmarks by hand-picking securities based on research and a defined investment strategy. Thus, actively managed funds offer the chance to outperform the overall market, although most of them historically have not.
An actively managed fund may be more diversified than an index fund holding stocks in the same asset category, because the manager can choose to weight the securities to meet the fund’s objective rather than following the market capitalization structure of an index. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.
Active managers also have more flexibility and may use a variety of trading strategies to help manage risks. For these reasons, some actively managed funds might offer defensive benefits when markets are falling, and they may be able to take advantage of specific market movements that might not be captured in an index fund.
There is ongoing discussion in the financial media around whether investors are better off using active or passive investing strategies, but there is no need to pick a side in the debate. Depending on your goals and risk profile, there may be plenty of room in a well-diversified portfolio for both types of funds.
The return and principal value of stocks, mutual funds, and ETFs fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. The performance of an unmanaged index is not indicative of the performance of any specific security. Individuals cannot invest directly in an index. Past performance does not guarantee future results. Actual results will vary.
Mutual funds and ETFs are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.