Actively vs. Passively Managed Funds

Investment statement depicting asset allocation
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If you've ever wondered what the difference is between an active or passive investment fund, understand that they're not the same, and 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).

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, like Fidelity's Magellan Fund under the guidance of Peter Lynch, posted huge returns. The Magellan Fund averaged a 29% return from 1977 to 1990.

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.
  • The Magellan Fund (the example cited above) is notable because it's the exception, not the norm, and few people could have guessed that it would do so well when it began. We only know how well it did with the benefit of hindsight.
  • 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 does 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 half a percent.

Examples of Passively and Actively Managed Funds

Passive: Bob puts his money in a fund that tracks the S&P 500 Index. Bob's 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 turns on the news, and the anchor announces that the S&P rose 4% today, Bob knows that his money did the same thing. Similarly, if he hears the S&P fell 5%, he knows his money did the same. Bob also knows that his management fee is small, and won't make a big dent in his returns.

Bob understands there will be some very slight variations between 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/sell decisions based on their predictions of those companies' performance.

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. When a news anchor announces that the S&P 500 rose 2% today, 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 onto 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.