Active and passive investing

Two ways in which mutual funds are managed.

Active and passive management are terms used to describe how much active decision-making goes into managing a mutual fund. 

Active management means a portfolio manager decides which stocks to buy and sell, how much of each and when to make trades. Passive management means a portfolio manager doesn’t actively make these decisions, but instead invests in stocks that mirror an index. 

 

Active investing aims to outperform the overall market. Often, Canadian equity funds will use the S&P/TSX Composite Index as its benchmark against which its performance is measured. A fund that has better performance than the index is outperforming the market, and one that has worse performance is underperforming. 

 

When a fund is passively managed, the goal is to generate investment returns that are the same as the overall market, or the index being mirrored. 

Active

  • A portfolio manager watches the fund every day

  • Could achieve specific goals like lower volatility

  • Often doesn't do better than the market

  • Fees are higher

Passive

  • No active decisions are made; automated investing

  • Matches the return of an index

  • Fees are lower

How you can use passive and active investments

You choose actively-managed funds or passively-managed funds or a combination of both. Here are some thing to consider when making that decision.

  1. More than half of actively-managed mutual funds in Canada do not outperform the overall market. This means that an investor would be better off investing in the market as a whole using an ETF or index fund than buying an actively-managed mutual fund. 

  2. There are other goals of active investing that should be considered. Some mutual funds aim to provide investors with a high level of dividend income, so they invest in high dividend-paying stocks. Other funds aim to have lower volatility than the overall market and invest in stocks that tend to have more muted ups and downs than the market as whole. If you have a specific need along these lines, you might find an active fund suits your needs.

  3. ETFs and index funds have much lower management fees that actively-managed mutual funds mainly because active management requires people to do research and make decisions, people who need to get paid. If you are confident that tracking an index is right for you (and it often is), you can save a lot of money over years of investing by holding a fund with a lower MER.

Anything else I need to know?

  • You can invest in index funds just as easily as you can buy an active mutual fund. Although the fees on index mutual funds tend to be higher than on passively-managed ETFs, index funds are a good alternative to active funds. 

  • Passively-managed funds are like robots: they just do what the index does. Actively-managed funds have people watching them every day, and a fund manager may be able to anticipate a negative event and switch up the investments accordingly to protect the fund from a loss. Yes, this isn't easy to do but sometimes it really works. 

  • ETFs were traditionally passively-managed, but you can also buy active ETFs. These are funds that deviate from the benchmark or index they use to measure themselves against. Fees on active ETFs are higher than passive ETFs.