Understanding the difference is foundational to investing
Investing can seem complicated. So much lingo, so many products. The truth is, though, that investing is actually quite simple once you break it down into pieces. There are really just five things you need to know about investing:
1. How to determine your appropriate asset allocation.
2. The difference between active and passive investing.
3. What ETFs and mutual funds are.
4. How to invest with an online broker and/or how to talk to your financial advisor.
5. When to revisit your asset allocation and make changes to your investments.
Take the time to understand these items one by one and you’ll see that investing is actually easy.
In my last blog post I wrote about asset allocation, a fancy term for how you divide your money into different types of investments, especially cash, stocks and bonds. This is the foundation of any investing plan.
The next piece to becoming an investor is deciding what types of investments you want to own. Your options include individual stocks, individual bonds, GICs, mutual funds, and exchange-traded funds (ETFs). There are more choices, but for most people, this list about covers it. And, to make it even simpler, mutual funds and ETFs are really all you need. In the next blog post, I’ll be writing about these products in more detail. But to understand what they are and how they work, you first need to understand passive and active investing.
What's the difference?
Active investing means that someone – a portfolio manager – is spending their days actively deciding what to own in the mutual fund they manage. Their job – all day, every day – is to try and pick the best stocks to own in the fund and buy and sell them at the right time. They along with their team of analysts do research, talk to management teams, read industry reports, attend conferences and crunch numbers. You can read more on this in a prior blog post.
A passively-managed fund is run by a portfolio manager who doesn’t make any decisions about what to own in the fund. They are not humming and hawing about whether to own more of Microsoft or Apple, or whether TD Bank will do better than Royal Bank. The manager simply mirrors an index, making no decisions about which to include or exclude.
What is a market index?
An index is simply a list of stocks that is used to represent a market. The most well-known is the S&P 500 index, a list of the 500 biggest companies in the U.S. It’s not all of the stocks available in the U.S. but these stocks are a representation of the market. When we talk about “the US market” we are usually referring to the S&P 500. Similarly, when we say “the Canadian market”, we are using the S&P/TSX Composite Index (“the TSX”) as a proxy for the market. There are indices for all kinds of market around the world.
The most plain vanilla ETFs invest in these broad-market indices. For example, the Vanguard S&P 500 ETF (ticker symbol VOO) simply mirrors the S&P 500. Due to its simplicity, the fee to own this fund is just 0.03% per year. This is roughly 1.8% to 2.5% lower than on actively-managed mutual funds. Why? There’s a lot less work involved in managing them and far fewer people who need to be paid. (Also, these ETFs don’t pay a commission to the sales person, a fee you that the investor actually pays for. You can read more on fees here.)
Active doesn’t mean better
The idea behind active management is that a human being can use all kinds of tools and resources to pick the best companies and stocks, and determine when they are cheap and when they are expensive. The goal is to have the actively-managed mutual fund do better than the overall market. In theory, this makes sense. In reality, though, it only works some of the time.
Managing a mutual fund that does better than the overall market is really, really hard. Every year, S&P does a study of how mutual funds have performed relative to the overall market. It’s not a happy report. It consistently shows that 95% of actively-managed funds in Canada do worse than (or the same as) the overall market, after accounting for fees.
This means that a passively-managed ETF that invest in the market index – like the S&P 500 – would do as well as or better than most actively-managed funds.
There are two reasons why most actively-managed funds underperform the market. The first is that performance of stocks is influenced by so many factors – many of which are irrational - which makes stock-picking a series of educated guesses.
The second is the fees. Fees on a mutual fund are deducted from the value of the fund. This means that if the investments in the fund went up 8% in a year but the fees on the fund are 2%, you as the investor only get 6%. The portfolio manager is handicapped by the fees, since they have to do as well as the overall market plus 2% to break even!
Why would anyone choose active over passive?
Why would someone choose a more expensive mutual fund over a cheap ETF? There are a few reasons.
For one thing, mutual funds are more accessible. Mutual funds are easy to buy and available anywhere – your bank branch, an investment advisor and through online brokerage accounts. ETFs, though, are not so easy to invest it; you can’t buy them at your bank branch and your advisor may or may not offer them. ETFs are most easily accessed through an online broker*, which means you’ll be managing your investments on your own.
Another reason is that some people like that there is a person keeping an eye on their investments and making adjustments when markets move. The idea that a human being can protect the value of your investment when markets are declining rapidly can feel reassuring. A fund manager might choose to sell some of the stocks in the mutual fund when they see something bad happening, like the financial crises. This can (maybe) minimize your losses as the market is plunging. This may be worth paying for if it helps you sleep better. But the manager also has to know when to get back in the market. Markets tend to rebound really quickly and it can be hard to tell whether an upswing is temporary or the real thing and the manager might mis-time that. Sometimes it’s better to just sit tight and wait out the insanity.
Lastly, and most commonly, many people don’t want to manage their own investments without help from a financial advisor. Since ETFs are most commonly accessible through on online broker, mutual funds might be the only option.
A couple of additional notes
Active management doesn’t just come in the form of mutual funds. Some investment management firms and financial advisors will invest your money in individual securities like stocks and bonds. They may also offer alternative asset classes like private equity and infrastructure. You might like having someone doing this work for you and to have someone to call when you’re nervous. If it calms your nerves to have someone looking after your investments, it could be worth paying for.
Passively-managed mutual funds do exist – they are called index funds. Index funds seem to be more commonly offered by financial advisors than ETFs are. This could be a great solution for people who want to work with their advisor but pay less in fees. The fees on index funds are lower than fees on actively-managed funds (but not as low as on ETFs) so ask your financial advisor is index funds are an option. (Note that index funds don’t pay a sales commission to the advisor so they aren’t always offered unprompted.)
The active versus passive debate is an ongoing one. Either choice is fine – just understand what you’re investing in and consciously make the choice.
*Every bank has an online broker and there are a number of independent ones. Some examples of online brokers include Questrade, TD Direct Investing and WealthSimple.
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