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Passive versus Active Funds

By Rick Imhoff, CFP ®

Mutual funds have been a popular investment vehicle for many years.  The first mutual fund was started in 1924 and over the following 50 years, several more were created.  All of these funds were actively managed, meaning an individual or usually a team of professional money managers decided which stocks, bonds, or other securities to buy, sell, or hold within the stated investment objectives of the fund.

In 1974, John Bogle started the Vanguard Group and late in 1975 created the first passively managed mutual fund, which follows the Standard & Poor’s 500 Stock Index.  A passively managed fund attempts to track the index it follows without making any judgment call regarding the retention, purchase, or sale of the securities to be held in the fund.  It just simply mirrors the index.

In 1990, the first exchange-traded fund (ETF) was created.  ETF’s are similar to mutual funds except they are traded like stocks throughout the trading day.  Mutual funds settle up with buys and sales at the end of the trading day.  Most ETF’s are passively managed, but over the past few years, actively managed ETF’s have come to market.

Another type of ETF that has been developed over the past few years is sometimes referred to as a Smart Beta ETF.  They are also sometimes called Factor Based ETF’s.  They provide an alternative strategy to traditional market cap-weighted indexes.  These type of funds are considered a blend of both passive and active investing that consider technical and/or fundamental investment factors such as size, value, momentum, and volatility.     

Today, there are thousands of mutual funds and ETF’s available to investors covering a wide range of investment objectives.  With all these choices, which fund or type of fund should an investor use in their portfolio?  For a starting point, here are three things to consider:

1 – Clearly identify your investment objective and only invest in funds that match those objectives.  Be sure to periodically monitor the holdings of the fund to see if they are staying true to their objective.

2 – All funds have an expense ratio which covers the costs to run the fund and to make a profit for the company offering the fund.  This is an on-going fee that you don’t see but that the fund has to overcome in order for you to start making money.  Passively managed funds tend to have a lower, if not substantially lower, expense ratio than actively managed funds.  Some mutual funds may charge an upfront or back-end sales charge.    

3 – Lower expense ratios don’t necessarily mean better returns.  Initially and periodically thereafter, you need to see how the fund has performed compared to an appropriate index or benchmark and against funds in its investment category.  It doesn’t have to be the top performing fund, but rather one that performs consistently over time and is ranked in the top 25% or higher within its category.

There are many other factors to consider when selecting, monitoring, and changing funds for your portfolio, but these three points can give you a good start to narrow down your choices.