Funds: Actively Managed vs. Passively Managed (Part 1)

What is the difference between Active and Passive Funds?

For many of those who are just starting to ease up to investing, things like stocks and commodities can be a little bit too overwhelming. With the sheer number of stocks moving up and down out there, it can be really hard to just even give it a start.

“Well, worry not,” a voice said.

“Invest in funds!” it says.

And you did. Funds are easy, right? You just put your money in there, and some magic elves would do the stock picking for you, and the next thing you know your money quadrupled! Haha. No. Stop that nonsense. Money isn’t easy unless you’re super smart (or rich). We’ll give a simple explanation of how funds work:

Fund is an idea — a strategy. Each fund is an idea that the fund creator tailored from their research and experiences. So, when you jump into a fund, you’re jumping into these ideas. If it’s good, you’ll make money. If it’s terrible, you’ll lose money. Simple enough, hopefully.

Here’s where many newcomers got it wrong — just because someone is managing your money, it doesn’t mean that it’s going to be good. Worse, sometimes the fund managers ARE good, but you don’t know what you want. You want to make money in the short term, but if you invest in long-term gain funds, it wouldn’t work too well.

As you go, there are generally two kinds of funds out there: Active and Passive.

Understanding Active and Passive Management

Active management involves the hands-on approach of fund managers who strive to outperform a specific benchmark index by actively selecting and trading securities. These managers rely on their expertise, market analysis, and research to make investment decisions.

On the other hand, passive management, commonly associated with index funds and ETFs, aims to replicate the performance of a chosen benchmark index. Instead of making individual security selections, passive managers simply hold the same securities in the same proportions as the index. They don’t aim to beat the benchmark but to follow it.

Here’s the scenario, in actively managed funds, your fund manager will first have one benchmark so that they can measure the fund’s performance. In many cases, they will use the S&P 500 Index as a benchmark. So, if the fund’s performance is better than the S&P 500, they’ll celebrate it as a win, and if it isn’t, they’ll get the ‘underperforming’ label.

In passively managed funds, your fund manager will look for a benchmark, not to beat it, but rather to follow/track its performance. For example, if they use the Nasdaq-100 index as their benchmark, they’ll go for stocks that they consider can replicate the Nasdaq-100 index’s movements. If the Nasdaq-100 goes up by 10%, they too, would expect to have the portfolio up by 10%. A slightly higher performance is considered a bonus.

Actively managed funds

You can almost say that there’s always an active fund for anything in your mind. Do you want a fund that’s focused on ESG? Sure thing! A fund that is all techs? There are so many lists of such funds out there. A fund that’s just filled with some weird penny stocks that you never heard of? Hop on! Getting into an active fund is like going to a club where the DJ will always have their mix for you to jam with, and they always shuffle their mix, so you won’t get bored.

When going with actively managed funds, there are a few pros and cons you’ll need to be aware of.

Pros:

Expertise and Research: In actively managed funds, you’ll get skilled fund managers bringing years of experience and knowledge to the table, allowing them to identify potential winners and losers in the market.

Flexibility: Active managers can respond quickly to changing market conditions, adjusting their portfolios to capitalize on emerging opportunities or mitigate risks. This is why active funds tend to outperform passive ones during a turbulent period.

Potential for Outperformance: A successful active manager may be able to deliver returns that outpace the market, especially in inefficient or rapidly changing markets.

Cons:

Higher Costs: Actively managed funds tend to have higher expense ratios due to the fees associated with research, trading, and management. I mean, given that they are constantly doing research and analysis of your funds, it just makes sense, doesn’t it?

Choosing fund managers: Despite their efforts, not all managers are super brilliant at consistently outperforming their benchmarks. In fact, research has shown that a significant percentage of actively managed funds underperform their benchmarks over the long term. There’s an interesting debate on this, but we’ll get to it specifically in another article.

Behavioral Biases: Active managers can be influenced by emotions, leading to decisions that are not always rational or aligned with long-term goals. However, with the advent of science, we have more quant-based or AI-incorporated funds that weed out emotions through these tools.

Passively Managed Funds

The most common passive funds out there are indices trackers kind of funds, which aims to only replicate an index’s performance, so it requires less intervention by the managers, apart from occasional rebalancing. However, there are also non-index funds which are usually in the form of ETFs. Even then, ETFs are usually rarely rebalanced.

If actively managed funds are like listening to a live DJ spinning their mix, passive funds are like listening to a playlist on Spotify that someone created. There’s a high likelihood that the kind of songs in there would remain the same for a long time, but sometimes some new songs would be added, and some would be taken off the playlist.

Passive funds also have their pros and cons.

Pros:

Lower Costs: Passive funds typically have lower expense ratios compared to actively managed funds since they require less research and trading activity.

Consistent performance: We don’t mean that it’s always up, sometimes it goes down. However, by tracking an established index, passive funds offer consistent and predictable performance relative to the market. Better off, the market decades ago showed gradual growth, only with a few hiccups, but they managed to pick themselves up again.

Lesser mistakes: Given that passive funds are not too often managed, they make room for lesser bad decisions. However, sometimes not making a decision can also be a bad decision in finance. It’s kind of like a double-edged sword. You can avoid human error by the managers, but sometimes you’ll take the hit head-on.

Cons:

Limited Upside Potential: Passive funds are designed to match the index’s returns, which means they won’t outperform the market. Although this doesn’t mean that you’ll lose money. Your money might still grow, but it would usually track the market performance, unlike active funds which seek to go beyond that.

Lack of Expertise: Passive funds lack the insights and decision-making of experienced fund managers, given how it is seldomly rebalanced and are usually left to trail the market. This means potentially missing out on unique investment opportunities, be it in terms of steering away from a crash or jumping into a new craze.

Market Bubbles and Inefficiencies: Since they don’t really have hands-on managers to handle it, passive funds can become overexposed to overvalued stocks in market bubbles or they may overlook potential undervalued opportunities that could’ve struck them gold.

Bottom Line

Actively managed funds are managed by fund managers who will constantly look for opportunities to maximize the fund’s performance, usually with the aim of beating a certain benchmark.
Passive funds are funds that are not actively managed. In many cases, they are created to trail the market performance of a certain benchmark.
There are pros and cons for both, but the most notable one is the risk-reward factor, whereby active funds tend to be riskier in the hopes of raking in more profit, while passive funds tend to be less risky in the aim of just following the market’s movements.
Both funds are useful, depending on your personal needs and risk tolerance.
Active or passive, a fund will essentially reflect the manager’s skill. If a manager is good, any kind of funds will eventually perform well, and vice-versa.

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None of the material above or on our website is to be construed as a solicitation, recommendation or offer to buy or sell any security, financial product or instrument. Investors should carefully consider if the security and/or product is suitable for them in view of their entire investment portfolio. All investing involves risks, including the possible loss of money invested, and past performance does not guarantee future performance.