Active vs. Passive Funds

With investment planning, one of the important factors to take into consideration is whether to choose an active or passive fund.  Both active and passive strategies aim to generate returns and achieve financial objectives, but they go about it in different ways. Knowing the difference between them is crucial for successful investment planning.

Active Funds

Active Funds are overseen by professional portfolio managers who actively buy and sell securities intending to outperform the index or to achieve a specific investment objective. Active managers may use various methods, such as a bottom-up approach that focuses on analyzing and selecting individual securities, or a top-down approach that adjusts sector and industry weights based on macroeconomic factors.

Pros of Active Funds

1. Potential returns greater than the benchmark – Skilled portfolio managers use extensive research to adjust portfolios, deciding whether to increase or decrease investments in specific stocks, bonds, or sectors compared to a benchmark.
2. Flexibility – Active funds can adjust to different market situations or take advantage of investment opportunities as they arise.
3. Diversification – Through active funds, investors may get exposure to a wide range of asset classes, sectors, and investment styles outside of a benchmark.

Cons of Active Funds

1. Higher fees – Active funds require extensive research, analysis, and management which comes at a higher price for investors.
2. Increased risk – The possibility of achieving returns above the benchmark involves accepting increased risks.
3. Potential for underperformance* – Historically, many active funds have failed to beat their benchmarks over the long term.

*According to the SPVIA Scorecard (a report providing on how actively managed funds around the world have performed, over both the long-term and short-term, against appropriate benchmarks), 78.68% of all U.S. Large-Cap funds underperformed the S&P 500 over a 5-year period as of December 31, 2023. In addition, 92.96% of Canadian Equity funds underperformed the S&P/TSX Composite over 5 years as of December 31, 2023*.

Passive Funds

Passive funds are an investment vehicle that seeks to mirror the performance of a market index, such as the S&P 500 or S&P/TSX Composite. Instead of spending time analyzing and researching which securities to include in an active fund, passive funds are more straightforward. They simply hold securities and adjust their weight according to a specific index in an attempt to match the returns.

Pros of Passive Funds

1. Lower fees and costs – Passive funds entail minimal management and don’t necessitate in-depth research or analysis for investment decisions, thus leading to lower expense ratios.
2. Transparency – Assets within the Passive fund are openly traded, providing visibility into the specific assets comprising the fund.
3. Simplicity – Holding onto an index or a set of indices is much easier to understand and manage compared to an active fund that needs ongoing research and rebalancing.

Cons of Passive Funds

1. Limited flexibility – Passive funds mirror a certain index or set of investments without much change. Therefore, investors will have to stick with those holdings, even if the market changes.
2. Market downturns – If the market goes down or is not doing well, passive funds will lose value just like the index that they are following.
3. Lower potential returns – Passive funds usually do not outperform the market as they aim to track the market while maintaining lower risks.

Both active and passive funds come with their own advantages and drawbacks. Active funds can potentially provide greater returns relative to the benchmark and provide flexibility, while passive funds provide consistent returns, lower fees, and broad market exposure. The choice of either an active fund or a passive fund plays a key role in investment planning.

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