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Active vs. Passive Funds: It’s More Than Just Fees

Author: Wealth Management Systems, Inc.

Since the first index fund was invented in 1975, the debate has raged between active and passive investing styles.

Passive investors adhere to the principal of market efficiency, which holds that all information available about a company is reflected in its current stock price. Rather than trying to second-guess the market, passive investors buy the entire market, or a specific segment of it, via index funds.

Active investors counter that the market is not always efficient and that through research, active fund managers may be able to uncover information not already reflected in a security's price and potentially profit by it. A less-than-efficient market, they reason, favors active stock selection.

Which is better? That depends on what you look at.

Performance

Over the years, numerous performance comparisons have been made between the two styles. Most have found that in the aggregate, passive outperforms active, especially after fees are taken into consideration. One of these, Standard & Poor’s SPIVA® (S&P Indices Versus Active Funds) U.S. Scorecard, found that 61% of all actively-managed domestic equity funds underperformed their benchmarks after expenses during the 10 years ended Dec. 31, 2014.1

But the results may be more mixed during shorter time periods or when different segments or investing styles are examined. For instance, in 2013, although actively managed large- and small-cap funds underperformed their benchmarks, actively managed midcap funds outperformed, as did actively managed growth funds in the large-cap, midcap, and multi-cap categories.1

Fees

Actively managed funds generally charge higher annual expenses than their index-based cousins. As of June 24, 2015, the average dollar-weighted expense ratios of actively managed domestic large-cap, midcap, and small-cap funds was 0.99%, 1.17%, and 1.24% respectively. By comparison, the index versions of these fund categories charged 0.14%, 0.17%, and 0.22% respectively.2 Although fee ratios for actively-managed funds have been trending down in recent years, they are still well above those of passive funds and are likely to remain so given that they require higher research and management costs and are consequently more expensive to run.

Takeaways for Investors

Although aggregate, long-term performance and fees both favor passive over active, there are some important points to be made in favor of active management. In certain segments, such as growth and international small-cap equity, active managers have tended to outperform the benchmarks more frequently, often when the economy and financial markets are in a state of flux.1 While active management cannot guarantee market-beating returns, it does offer the potential to capitalize on market shifts and the flexibility to take advantage of different investing strategies. Active managers also appear to have the edge in markets that are not efficient and when implementing investment strategies that are complex and fast moving. Such circumstances can pose issues for index funds, which typically must adhere to a predetermined set of rules and may not be able to respond as nimbly as active managers.3

In practice, a blended approach may be the best answer. Consider index funds for efficient markets and active management for less efficient areas. When the broad market turns volatile, adding a defensive, actively traded fund to a portfolio of index holdings may help to smooth out bumps and moderate overall portfolio risk. Alternatively, passive investors can potentially build risk management into their portfolios by diversifying among a range of index funds covering a wide, varied swath of the market.

Keep in mind that how you construct your portfolio should consider much more than performance and fees.

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