Active versus Passive Investing Management

Despite all the doom and gloom, investing is not a waste of money. You just have to know where to invest your money. Reading a lot helps. Reading and deciphering the information helps even more. And when investing, investors make the choice to actively or passively manage their investments.

I’m sure most of you know the difference between active vs. passive management, but for good sake we’ll go over it again. The difference between active versus passive investing is like the difference between the actions of one individual versus the actions of a group or you can think of passive investing as group of individuals profiting on the overall income brought in from hosting a Stanley Cup party versus one individual betting on the winner of the Stanley Cup final.

Mutual Funds – which are collections stocks and sometime bonds, are often considered the simplest and best way for most people to invest. But we’ve seen fund managers fail over and over trying to beat the market. And on top of it all, even with good performance of a mutual fund, the return is hampered by the large fees of a fund manager.

Despite large fees, most portfolios in Canada are managed through a financial adviser, who uses active management strategies. Furthermore – financial adviser offers advice and other services to their clients.

However, there is significant noise being made by investors who are foregoing the financial adviser and rather choosing to manage their portfolio them selves – passively. And by managing the portfolio without an adviser, more investors are joining the DIY movement as illustrated in this article.

When it comes to investing, fees are a huge drag on the returns. This is a little counterintuitive since we’re used to paying for services, like our gym memberships and admission to the theme park. And if were getting something in return, we should pay a fair price, right? Sounds about right, but the key word is fair. Yet, many financial experts (as we call them) that we turn to for guidance make every effort to squeeze every penny out of us.

Mutual funds are a great example of active management. Essentially a portfolio manager is actively trying to pick the best stocks, with the hopes of giving you the best return. Despite all fancy analysis, their support team and today’s technology, even portfolio mangers make mistakes such as selling too quickly, trading too frequently and making rash decisions.

Furthermore, these fund mangers trade frequently to show short term gains and prove that they are doing something to earn the investors money. Remember earlier on when I said that the same fund mangers usually fail to beat the market, well this is true and when they fail, they still charge us a fee. Sorry, I know I failed and you lost money, but I still got to charge you 1.5 percent. That percentage fee adds up – on $10,000 portfolio you’d pay $150 per year in fees. And most would agree, that 1.5 percent does not sound much until you compare it to the alternative: passive investing.

This is where index funds come in. A cousin of mutual funds works by replacing expensive portfolio managers with computers. No hot stock picking, but rather in a simple manner the same stocks are picked that a certain index holds.

Each year studies are done, comparing actively managed funds versus passively active funds. And each year the results are more of less the same, which show very marginal or no outperformance at all when putting active funds versus passive funds head to head. Yet, the fees remain the same or keep rising. Funny how that happens, don’t you think?

I’m by no means a professional investor, in fact I don’t invest at all, at least not yet, so I’m not going to get into the math of passively managed portfolios versus actively managed ones, but I will leave you with two great examples:

• Canadian Index Funds – Fee Comparison
• Active vs. Passive Investing Strategies  – Excellent Example (5^th paragraph in)

To sum it up, actively managed funds have higher fees simply because they carry more overhead. It takes time to do the research and you have to pay someone to do it. Furthermore, the trading costs are higher for actively managed funds, because they are always in and out of stocks. Passively managed funds carry virtually no overhead and the savings are passed down to the investor.

If the investor’s decision is determined by fees alone, passively managed portfolio would be the way to go. On the retrospect, if the investor is unsure of where to start and would rather have someone do all the work, yet does not mind the fees, than actively managed portfolio might be the way go.

Eventually when I get into investing, after all my debt is paid off I will choose a passive investing strategy. My decision is simply based on fees and that I’m looking for long-term growth, rather than speculating the next hot stock. Sure, it will be a steep learning curve for me, but I’ll be ready when the time comes.

For those who are looking to use a broker or actively managed fund, do your research and pose one simple question to any broker you talk to: “What were your after-tax, after fee returns for the last seven years”? Their answer won’t be a straight one, simply because they would be admitting to you that they didn’t beat the market.

Eddie