Ep. 46: Active and/or Passive Investing?

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Welcome back to Money Matters! My name is Michael and I’m here to help guide you in becoming a better and more confident investor. In this episode, I want to talk about active and passive investing and then you can decide which would be best for your investment needs. It’s no secret that this debate has been going on amongst investors and scholars alike for decades and will continue on for decades to come, but it’s really how you the investor feels about these funds, and if you’re going to hang onto these funds is all that matters. In recent years the trend has been favoring passive investing from a performance standpoint, but going forward no one can predict if this will continue.

Let’s first breakdown the key difference between active and passive fund investing. Active Funds attempt to outperform a specific index, often called their benchmark. They hire portfolio managers and analysts to try to make this outperformance happen. Which then results in higher expenses and fees.

Passive funds are designed to match, not beat, the performance of a specific index. And because this fund isn’t trying to outperform a benchmark they’re generally automated, with very little human oversight. And because of this automation, these funds typically have much lower expenses than actively managed funds.

Now with a quick introduction out of the way, let’s talk about the pros and cons of active investing. The pros of actively managed funds are – you the investor purchases an actively managed fund because you think it will do better than say the S&P 500 – so in that instance, you’ve hired these portfolio managers and analysts to do research and pick stocks or sectors that they feel are in favor that year to outperform which sometimes this does happen. The S&P 500 may be up 10% on the year and your fund may be up 14% on the year after those extra fees and expenses. This is great in this instance because you’ve justified paying more money for this outperformance! This however does turn out to be way more difficult than you’d think. For instance, 71% of large-cap U.S. actively managed equity funds underperformed the S&P 500 according to the S&P Dow Jones Indices Scorecard. My philosophy is quite simple in this regard. I personally don’t mind paying for some active management when I know the investment has potential to outperforming the benchmark net of fees, otherwise, if it continues to underperform I question what I’m paying for.

When discussing passive investing, or index funds I’m looking to match the market’s activity at a fraction of the cost. Where I see the confusion on indexes is – they are designed to match the performance of the market – meaning when markets go up so does this investment, but make sure you’re ready for when markets move in the other direction – because if markets go down so does your investment are they are very highly correlated. You’re along for the ride. But you get what you pay for. I personally own some index funds because I know I’m holding them for the long-term and I know they’re extremely affordable. I’ve done another video on Expense Ratios I would encourage you to check out because over time those extra fees add up and compounded over years can end up costing you thousands of dollars. Index funds can be an affordable way to purchase quality investments, just don’t expect the performance to protect your downside capture.

So what’s the takeaway here? I feel there is a place for active and passive investments in your portfolio, as I do invest my money in the very same fashion. And because of the rising popularity of indexing, it has been driving the cost of active funds down which is a win for investors everywhere! If you’re someone who wants to just set it then your portfolio might be more passive investments. If you’re someone who cares more about the fate of your investments then find some actively managed fund and allocate more of your money towards those positions. Just make sure you’re doing your homework on those actively managed funds, because as I discussed earlier in the video – not all actively managed funds are even outperforming their benchmark! There is of course no guarantee that these investments will meet their goals. And then lastly think about your life and what you need your money to do for you? Do you need to be taking more or less risk? This is where coming up with a financial plan can really help you make these decisions. If you’re needing help with starting to create a financial plan know that I would be happy to have that conversation with you. Thank you for watching and as always thank you for giving your finances that attention that they deserve.