Active vs Passive Equity Funds
Active funds are mutual funds that select investments in an attempt to outperform an established benchmark. Passive funds hold a basket of securities based on the index they track, aiming to match the benchmark’s performance. Both active and passive equity funds seek to provide returns above inflation (and taxes) but do so differently.
From an investors perspective
From this perspective, you must understand the difference between a mutual fund and a portfolio. A mutual fund will pool money from many people who invest at different levels with varying degrees of risk. On the other hand, a portfolio is simply one person’s collection of investments purchased at their own discretion. This individual will typically have control over where this money is invested and how much goes into which investment/s.
Active investors seek to outperform through research and will often purchase stocks that they feel are undervalued. The expectation is that the market will eventually correct itself, leading to an increase in share prices. This can be rewarding when it works but is typically a risky strategy that requires significant time and effort.
Passive investors are not concerned with researching securities themselves; instead, they are more interested in investing their money into securities that behave according to specific rules or patterns. Passive funds invest by tracking specific indexes, for example, mutual funds or exchange-traded funds (ETF’s), which hold all companies included in a market index regardless of their size or financial health. The idea is that you cannot outperform simply by picking great stocks because there will always be some stocks that go up while others go down regardless of their value.
Studies suggest that it is nearly impossible to pick individual security that will outperform its market for an extended period (five years or more). This means that you are better off selecting a group of securities within the same industry because if one goes up, then others in the same industry will typically follow suit. It is this fundamental idea that led to the creation and success of index funds. Instead of trying to identify when stocks will go up or down, you can simply select a basket filled with securities from different parts of the market and be confident in making money over time.
From a cost-effectiveness standpoint, although both active and passive funds require some management fees, these charges tend to be significantly higher for active funds. This is the result of the increased labour costs associated with active mutual fund management. Active managers must be compensated for their work in addition to shareholders salaries, overhead expenses and other indirect costs that are not incurred by passive products which track an index.
According to Morningstar, the average expense ratio for actively managed equity funds is 0.84% annually, while passive equity funds charge around 0.18% yearly (note this does not include any additional fees charged by the company holding your investments). While this may seem like a fairly significant difference, consider that you can net up to $300 000 in your tax-free savings account (TFSA) over the next five years using just $600 per year in contributions multiplied by the number of years you save.
If we assume that an investor invests $6000 each year, this would mean they are investing $30 000 over five years while receiving only $18 000 in returns (not to mention losing out on an additional 6 % yield opportunity). This means that even if the difference between passive and active management fees is more significant than 6%, it still makes sense for investors to choose passive funds because of the increased cost-effectiveness.
The TFSA was explicitly created with tax efficiency in mind; contributors pay no taxes on interest earned or capital gains accrued within their accounts, and in addition, all withdrawals (including interest and capital gains) are tax-free. Passive funds can be even more tax-efficient than TFSAs because they do not incur dividend income; this is money paid to shareholders in the form of dividends that come from a company’s earnings. On the other hand, active fund managers must pay out these dividends (because it’s their job), which means that investors must also pay taxes on these funds within their overall taxable income for the year.