The investment landscape today is different than it was a decade ago. Advisors mainly used mutual funds to build investment portfolios for their clients. Today, there are so many more investment options available, which has led to more competition. As a result, the cost of investing has come down which is good news for investors.
There are two broad investment categories in the marketplace today, active and passive funds.
An actively managed fund is a fund in which a manager (or a management team) makes decisions about how to invest the fund’s assets. The fund portfolio manager actively picks stocks or bonds to invest in while also determining the best time to buy and sell those securities. Active funds typically charge a higher fee for the opportunity to outperform the market based on the manager’s investment decisions.
A passive fund, by contrast, simply follows a market index. It does not have a manager making investment decisions and typically comes at a cost that can be significantly less than an active fund. It is built to mimic the profile of an index, the most popular being the S&P 500, but there are other popular indexes as well. Passive funds simply seek to match the risk and return of the index they are replicating.
Should investors favor one over the other?
We get asked this question quite often from our clients. To properly answer the question, many factors need to be considered.
To start with, most research today shows that the average active fund has failed to consistently outperform the market. However, the same research also shows that skilled managers do exist but are rare and difficult to identify in advance. They may also come at a higher cost. The challenge for the advisor is determining if the fee charged for the active fund is too high to outweigh the benefits.
Also, in certain segments of the equity or bond markets, fewer active managers consistently find success relative to the market. At the same time, the number of passive investment options available continues to grow, offering investors more options to choose from.
As we search for skilled active managers, low fees are still the most important factor and the most reliable predictor of future performance. There are however other characteristics that can increase the probability of an active manager outperforming the market:
- Concentrated portfolios: The manager shows conviction in the companies in which they are investing.
- Low turnover: The overall investment philosophy fosters a long-term approach to investing.
- Alignment of interests: The fund manager demonstrates an appetite for the strategy by investing his/her own money into the fund.
In our opinion, the best balance between costs and returns in a portfolio is accomplished by having a combination of active and passive funds. This can provide:
- Reduction in costs/fees
- Improved risk-adjusted returns
- Opportunity to outperform the market
- Potential for improved tax-efficiency