Active versus Passive – The Great Debate
In the investment world, there are two broad schools of thought: active and passive. Active investors use a variety of strategies, but essentially believe that it is possible to apply their skill and knowledge to produce returns that exceed a benchmark index. Passive investors, on the other hand, believe that it is impossible for any fund manager to consistently produce returns above the index.
While arguments can be made on both sides, most research points to the fact that active mutual funds generally do not beat the index consistently over time. There are many reasons for this trend, including the fact that active management costs much more than a passive indexing strategy. No matter where you sit on this debate, there are sound reasons for including at least some passive investments in your portfolio.
Low Cost
The management expense ratio (MER) is typically much higher on an actively-managed fund than on an index fund. The reason for this is that active management depends on a staff of analysts who pore over corporate reports and make site visits to companies they may wish to purchase. Because index funds match their investments to a particular stock index, there is no need for ongoing research.
Low Taxes
Active investment managers are constantly buying and selling companies within their fund, which means that there are additional trading costs, as well as capital gains. When held in a non-registered account, these gains are taxable to you, the unit holder, even though you may not have sold any of your units. Index funds only buy or sell companies when changes are made to the underlying index, making them extremely tax-efficient.
Simplicity
Choosing an active fund manager can be a complex process. You may decide to invest in a particular fund because of the stellar track record of the manager. But what if the manager moves on to another firm? What if the manager’s approach no longer fits with the market trends of the day? Because so much of the success of the active approach is riding on the shoulders of the fund managers, you really need to keep on top of current events in the fund industry. This is not an issue with the passive approach.
If you’re thinking of implementing a passive approach, you can choose from either index funds or exchange-traded funds (ETFs). Both investments are designed to track a specified target index or benchmark. However, there are some important differences to be aware of. See below for a brief introduction.
Index Funds and ETFs – What’s the Difference?
Index Funds
- Traded like a mutual fund – bought from and sold to the fund company at end-of-day values
- Can usually be bought on a no-load basis
- Best for smaller accounts or for people who make regular monthly contributions to their investment account
ETFs
- Traded like a stock on the open market at prices that fluctuate throughout the trading day
- Brokerage fees required to buy and sell them
- Best for larger accounts or for people who invest in a lump sum once per year
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