The decades-old debate over active versus passive investing has turned into a muddle where it’s unclear which side is which.
The first shot was fired in the 1990s when index index funds (ETFs) entered the market. These ETFs have given investors indirect access to stocks traded on all of the major global indices such as the Toronto Stock Exchange and the Nasdaq, and even specific sectors within them – all for a fraction of the cost of one. actively managed mutual fund.
Typically, active investing puts investment decisions in the hands of professional fund managers, and passive investing puts investment decisions in the hands of every market player.
When it comes to which method reaps the greatest rewards, the results vary depending on how the data is sliced and sliced. Actual returns from objective trackers show that actively managed mutual funds have the overall advantage; but, in a cruel catch-22 for investors, they underperform once the fees are applied.
There is no single definition of active or passive management these days, but there are degrees that can help you determine if the fees you’re paying match the services you’re getting.
THE ACTIVE MANAGER
In its purest form, active managers are professionals who invest on behalf of a client based on the individual’s goals and risk tolerance. They are part of a team that determines the best investments to buy, hold or sell.
Active managers, such as the team led by Warren Buffett, are trained to identify a company’s profit potential as well as potential risks by going through the company’s quarterly profit statements and often establishing direct relationships with The direction.
They assess the entire industry, market, and economy at a macro level and determine whether the company’s profits justify its current price levels.
Active managers can employ countless methods to determine value, but the only thing they share is that they are actively investing.
The most common way for retail investors to access active management is through mutual funds. The annual fee for practical management can exceed three percent of the total investment.
In its purest form, passive management attempts to replicate larger indices by tracking individual holdings according to their weight in the index and adjusting them daily as they change in value. No arbitrary decision is made. They stare at it and forget it.
As a result, price changes of S&P 500 ETFs – for example – will reflect price changes of the actual S&P 500 minus a nominal fee. Annual fees on ETFs could be as low as a tenth of a percent.
SOMEWHERE IN THE MIDDLE
Index ETFs were quickly followed by other passive investment products such as equal weight ETFs aimed at placing more emphasis on smaller holdings with greater growth potential in an index.
This is still a predefined formula, but it has paved the way for a multitude of complex predefined formulas, which generally fall under the rubric of “smart-beta” ETFs. In many cases, including or combining different passive investing strategies is like active management. So are the higher fees that come with more complicated “passive” strategies.
ETFs have grown in popularity as retail investors increasingly realize the destruction that active management fees inflict on their portfolios. Demand has spawned discount brokers offering ETF portfolios and robo-advisers that automatically determine which ETF combination is suitable for individual investors.
Oddly enough, discount brokers themselves often market passively managed ETF portfolios as actively managed.
At the same time, many actively managed portfolios bear a striking resemblance to their benchmarks. Take a look at the largest holdings in just about any Canadian equity fund and compare them to the largest holdings in the S & P / TSX Composite Index.
The term is “shelving” and it basically means paying a lot to an active manager to pay a lot less for a passive investment. In other words, this expensive active manager does little more than replicate a cheap ETF.
To make matters worse, mutual fund investors might have to pay an additional annual fee – typically one percent of the amount invested – if they buy a fund through an advisor.
It’s called a trailing commission and is designed to compensate the advisor for their active management layer, which begs the question: is an advisor who sells pre-packaged portfolios an active advisor?
Many Canadians choose to pay higher fees for professional management and it often pays off. It would help to know that you aren’t paying more for something less.