If you've ever wondered what's the difference between an active and passive investment fund, understand that one may fit your investing situation better than the other.
An actively managed investment fund is a fund in which a manager or a management team makes decisions about how to invest the fund's money.
A passively managed fund, by contrast, simply follows a market index. It does not have a management team making investment decisions. You'll often hear the term "actively managed fund" in relation to a mutual fund, although there are also actively managed ETFs (exchange-traded funds).
You shouldn't assume that you have an active vs. a managed fund simply based on the fund type. You may find one or the other in a variety of categories, so be sure and read the prospectus of any fund you're considering so you'll know the details.
- Both types of funds have their uses, and investors have to decide for themselves which type better matches their style.
- Actively managed funds offer the opportunity to beat the market, but they typically charge a higher fee, and many fail to beat the market consistently.
- Passively managed funds are cheaper and perform more consistently, but your performance is—by definition—the average.
The Pros and Cons of Each
The personal finance community likes to debate about whether actively managed or passively managed funds are superior. Supporters of actively managed funds point to the following positive attributes:
- Active funds make it possible to beat the market index.
- Several funds have been known to post huge returns, but of course each fund's performance changes over time, so it's important to read the fund's history before investing.
On the other hand, actively managed funds have several downsides:
- Statistically speaking, most actively managed funds tend to "underperform," or do worse than, the market index.
- We cannot know how well any particular fund will do by reading historical data. In reality, there's no way to predict how well any fund will actually perform.
- Every time an active fund sells a holding, the fund incurs taxes and fees, which diminish the fund's performance.
- You'll pay a flat fee regardless of whether your fund does well or poorly. If the index offers a 7% return, and your active fund gives you an 8% return but charges a 1.5% fee, then you've lost .5%.
Examples of Passively and Actively Managed Funds
Passive: Bob puts his money in a fund that tracks the S&P 500 Index. His fund is a passively managed index fund. He pays a 0.06% management fee.
Bob's fund is guaranteed to mimic the performance of the S&P 500. When Bob turned on the news, and the anchor announced that the S&P rose 4% today, Bob knew that his money did just about the same thing. Similarly, when he hears that the S&P fell 5%, he knows that his money did just about the same. Bob also knows that his management fee is small and that it won't make a big dent in his returns.
Bob understands there will be some very slight variations between the performance of his fund and the S&P 500, because it's nearly impossible to track something perfectly. But those tiny variations won't be significant, and, as far as Bob is concerned, his portfolio is imitating the S&P.
Active: Sheila puts her money in an actively managed mutual fund. She pays a 0.95% management fee.
Sheila's actively managed fund buys and sells all kinds of stocks—banking stocks, real estate stocks, energy stocks, and auto manufacturing stocks. Her fund managers study industries and companies and make buy-and-sell decisions based on their predictions of those companies' performance statistics.
Sheila knows that she's paying almost 1% to those fund managers, which is significantly more than Bob is paying. She also knows that her fund won't track the S&P 500. A news anchor announced that the S&P 500 rose 2% today, but Sheila can't draw any conclusions about what her money did. Her fund might have risen or fallen.
Sheila likes this fund, because she holds on to the dream of beating the index. Bob is stuck to the index; his fund's performance is tied to it. Sheila, however, has a chance of outperforming (or doing better than) the index.
After reviewing these examples, you can see the reality of how the two different funds operate so you can have a better idea of which might work for you.
Frequently Asked Questions (FAQs)
What percentage of actively managed funds beat the market?
SPIVA, which is a part of S&P Global, regularly reviews actively managed fund performance relative to the overall market. In the past year, just under 42% of actively managed, large-cap U.S. funds beat the market. In the past 10 years, that figure drops to about 17.5%.
What happens when actively managed funds don't beat the market?
In short, nothing happens when actively managed funds fail to outperform the market. Investors aren't guaranteed any level of performance when they buy actively managed fund shares. If an investor is upset about the performance of a fund, their only option is to sell their shares in that fund.
Which Vanguard bond funds are actively managed?
Why do passively managed funds tend to have low fees?
There are fewer decisions to make, and trades to place. It also takes less general effort to exert with passive funds. The bulk of passively managed fund operations can be automated, and the fund manager simply has to oversee and fix any complications that arise. That is much cheaper than paying experts to decide for themselves when and what to buy or sell.