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Are active funds better than passive funds or vice versa? The debate rages on. To help determine which may be better for your portfolio, it helps to understand how they differ.
Active investing involves the skills of an investment manager who seeks to generate greater returns than a market benchmark or index and may pursue other goals, such as reducing risk and enhancing income. Active investing includes substantial research and, possibly, a fair amount of trading, and the manager generally passes these expenses on to the investor.
A passive manager’s investment strategy, on the other hand, is designed to track the performance of an index, an asset class or market segment (benchmark) and achieve returns that closely correspond to the returns of that benchmark. The goal of this type of investing might be, for example, to track the performance of the S&P 500 Index, which means owning a basket of stocks that mirrors the index’s composition. Once the basket’s contents are determined, the manager generally steps back and lets market forces do what they will.
With this type of investing, the manager will not sell securities to take advantage of changing market conditions and may have less flexibility to react to price declines in the securities but will continue to hold the same securities as the benchmark it is designed to track.
The expenses for a passively managed fund, such as an exchange-traded fund (ETF), are usually low, making it comparatively inexpensive for investors to own. It is important to note that although these funds trade relatively infrequently, keeping administrative expenses relatively low, this means the fund’s performance probably will not match the benchmark’s performance exactly.
Investors may find these low expenses attractive, but actively managed funds could have an advantage during periods of market volatility. While a passive manager’s hands are essentially tied during these times, an active manager is able to make adjustments to the portfolio in an attempt to improve its performance. Although there’s no guarantee these efforts will prove successful, the active manager — unlike the passive manager — at least has room to maneuver.
Wide range of alternatives
Because there are literally thousands of funds on the market, deciding on active investing opens the door to a broad range of additional choices.
There are funds concentrated on a specific level of capitalization, or cap — a term used to describe a company’s size. It’s determined simply by multiplying a company’s stock price by the number of shares in the market. In addition to large-cap, such as those in the S&P 500, there are also mid-cap and small-cap companies.
In addition, there are funds focused on different investing styles. Growth funds invest in companies that appear poised to grow faster than their market sector or the market in general, although growth may not be realized. Value funds, on the other hand, look for companies that investors appear to be overlooking for one reason or another and show promise for a comeback, but there is no guarantee the overall market will recognize such value.
Some funds look to generate income by investing in companies that pay dividends. Investors can receive that income as cash or reinvest it in additional fund shares. However, keep in mind that reinvested income generally is taxable in the year it’s paid unless it’s held in a tax-advantaged account, such as an IRA.
Remember to diversify
The debate over active vs. passive is somewhat pointless because you don’t have to choose between the two. In addition to spreading your money across a variety of different asset classes (stocks, bonds and cash), market capitalizations (large, medium and small), and investing styles (growth and value), you can also diversify by including both passive and active investments in your portfolio. For help with building a portfolio designed to help you reach your goals, consider turning to a professional financial adviser.
Exchange-traded funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed, or sold, may be worth more or less than their original cost. Exchange- traded funds may yield investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched.
Asset allocation and diversification cannot eliminate the risk of fluctuating prices and uncertain returns nor can they guarantee profit or protect against loss in declining markets.
All investing involves risk, including the possible loss of principal.
This article was written by/for Wells Fargo Advisors and provided courtesy of Jamie Seim, CFP, Senior Vice President – Investment Officer in Ponte Vedra Beach at 904-273-7917.
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