What You Need to Know About the Passive vs. Active Management Debate

By Markets Fool.com

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For years, a big debate has divided the investment world and it all comes down to two words: active and passive.

Some argue that investors are best served by passively managed funds -- low-cost funds that track indexes such as the S&P 500 or the Russell 2000. Others staunchly support active funds -- funds run by investment managers who try to beat the indexes.

While there are advantages and disadvantages to both strategies, investors have been shifting dollars away from active funds to passive mutual funds and passiveexchange-traded funds(ETFs). Why? Simply put, as a group, actively managed funds, after fees have been taken into account, tend tounderperformtheir passive peers.

In 2013, actively managed equity funds attracted $298.3 billion, while passive index equity funds saw net inflows of $277.4 billion, according to Thomson Reuters Lipper. Fast-forward two years: in 2015, passive index equity funds netted $299.1 billion, while active equity funds saw net outflows of $97.9 billion.

Russel Kinnel, the editor of Morningstar FundInvestor, called the trend "flowmageddon," noting that 18 "Morningstar 500" fundsall of which were activesuffered outflows of at least 40 percent of assets under management from March 2015 through February 2016.

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"Something big is happening," Kinnel wrote in a recent column. "More advisors are switching to [passive] ETF-focused strategies, and, when they get a new client, they quickly sell the weakest-performing active funds -- possibly all the actively managed funds in the client's current portfolio."

Want to learn more about the active vs. passive debate? Read on.

What are the key differences between active and passive funds?

Passive funds, also known as passive index funds, are structured to replicate a given index in the composition of securities, and seek to match the performance of the index that they track, no more or no less. That means they get all the upside when a particular index is on the upswing and all the downside when that index falls. And as the name implies, there is no manager or management team actively picking stocks or making buy and sell decisions.

"Passive vehicles are based on indices," said Aye Soe, senior director and head of the North American research team at S&P Dow Jones Indices. "They have to remain invested at all times."

Active funds, in contrast, attempt to beat the indexes, thoughand this is importantthere is no guarantee that they will do so.

Active managers conduct economic, sector and company research, while employing strategies such as market timing. For instance, if an active fund manager believes a particular sector, security or asset class is heading for a decline in value, he or she might reduce that fund's exposure accordingly.

But this active involvement comes at a price. Actively managed funds are typically much more expensive than index funds. The average expense ratio for an actively managed equity fund is 1.4 percent, while the average expense ratio for a passive equity fund is 0.6 percent, according to Thomson Reuters Lipper.

While the difference between 1.4 percent and 0.6 percent might not seem like much, it can add up over time.

Say you invested $10,000 in each of two funds. One fund has an annual fee of 0.6 percent, and the other has an annual fee of 1.4 percent. If both returned 5 percent annually for 10 years, that lower-cost 0.6 percent fund would be worth about $15,380 whereas the 1.4 percent fund would be worth about $14,240, or about $1,140 less. And the difference would only compound over time, with the lower cost fund worth about $3,374 more after 20 years.

In addition, managers of active funds tend to trade their holdings more frequently. That might lead to higher transaction costs or trigger capital gains taxes that are shouldered by the funds' investors.

Active funds cost more, but do they outperform?

Researchshows that relatively few active funds are able to outperform the market. That is in part due to their higher fees.

"They must first beat the index, and then beat the expense ratio," said Tom Roseen, head of research services for Thomson Reuters Lipper.

Last year, for instance, 66 percent of large-cap U.S. actively managed equity funds underperformed the S&P 500, according to S&P Dow Jones Indices' SPIVA (S&P Indices Versus Active) Scorecard, a measure of the performance of actively managed funds against their relevant S&P index benchmarks.

Over the last ten years, 82 percent of large-cap, active U.S. equity funds underperformed.

"The majority of managers have a difficult time beating the benchmark," Soe said.

Where do "smart beta" funds fit in?

Recently, there has been significant growth in the number of financial products seeking to track the performance of alternatively weighted indices, commonly referred to as "smart beta" indices. Such indices might carry names like Strategic, Alternative, Advanced, Enhanced, or Scientific -- labels meant to convey that something more than passive tracking of a market-weighted index is involved.

Smart beta indices may be relatively simple or more complex. For example, a smart beta index may be constructed to weight all underlying component stocks equally, or a product may be linked to fundamentally weighted indices, in which the index components are determined based on companies' revenues, dividends or other corporate metrics.

Products that track smart beta strategies are usually less expensive than actively managed funds, but tend to be more costly than funds that track market-cap-weighted indices. But because many of the exchange-traded products tracking smart beta indices are relatively new, they may be relatively illiquid, and there may be extra investing costs linked to that illiquidity. For a broader list of considerations, check out the Financial Industry Regulatory Authority'sinvestor alert.

What is the takeaway for investors?

Deciding between passive and active funds may not be an either-or decision.

For someone who doesn't have time to research active funds, and doesn't have a financial advisor, "passive is probably better," Roseen said.

But "for someone who's at least partially involved, they may be able to create a well-diversified portfolio and may be able to build value by putting active and passive together," Roseen said.

Keep in mind, not all active funds are equal. Some might have lower fees and a better performance track record than their active peers.

"Do your homework," Soe advised. "Look at data." But remember that just because a fund -- active or passive -- performed well last year is no guarantee that it will perform well again.

Think about your own financial situation, your life stage and your ability to tolerate risk, before you invest your money. When it comes to comparing fees, the FINRA'sFund Analyzercan help you understand how much you are paying for a given fund. While cost shouldn't be the only factor you consider, it is certainly an important one to consider. Those are smart moves that aren't up for debate.

This article originally appeared on thealertinvestor.com.

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