Passive or Active Management

Stock mutual fund investors have the choice of investing in either passive or active funds. What is the difference and why does it matter?

WHAT ARE ACTIVE FUNDS? Actively traded mutual funds are probably the oldest and most common form of mutual fund. Actively traded funds have a fund manager who oversees the selection of stocks which will be in the fund in an effort to meet his stated objective.

Step2

WHAT ARE PASSIVE FUNDS? Passive funds are more or less on autopilot. They are funds comprised of a pre-determined basket of stocks, usually mimicking a particular stock index like the S&P 500, Dow Jones Industrials, or Russell 2000. Passive funds are commonly referred to as "index funds". The passive fund therefore normally has very little "turnover" or changes in the individual stocks within the fund. A sale or purchase may happen when a company is added to or subtracted from the index.

Step3

FEES - Because passive funds are based on an index and are basically on auto-pilot, it takes very little oversight to keep them running according to their objective. Consequently passive fund investors enjoy lower costs in their funds relative to active managers. You can easily find passive S&P500 index funds, for example, that charge as low as %0.10 per year. Not bad! On the other end, active fund managers have significnatly higher administrative costs, including for example salaries for the fund managers, equity analysts, office managers, marketing managers, etc. Consequently it is common to find that these funds charge an "expense ratio" in the neighborhood of 1.0%-%1.7%. Obviously, lower is better all things being equal. Of course if the manager has a proven strong track record, some people will argue that he deserves his higher fee... but passive index investors don't agree.

Step4

PERFORMANCE - The bottom line! It is commonly said that 70% of all active managers fail to outperform their benchmark index after fees. That's pretty amazing when you consider how much money is invested in active managers! Anyhow, for this reason index funds have become increasing popular as investors can outperform 70% of active managers primarily because of the lower cost. Why do people continue to invest in active funds? Some people find investing in indexes just too boring! And they also believe they can identify the 30% of managers who do beat the index. Beyond that, they also believe that if they fail at finding a winning manager, the downside probably won't be so bad, whereas the upside could be great! The irony behind the situation is that passive investors couldn't exist if it wasn't for all the active managers out there who make the market efficient and rational. If everyone invested in passive funds, the market would become irrational and active managers could find ways to beat the index! But you don't have to worry about that - there will always be enough active investors to keep the passive investors smiling and winning 70% of the time!

By ehow.com