Funds: Actively Managed vs. Passively Managed (Part 2)

How to choose which fund is best for you?

Before this, we’ve spoken about the pros and cons of investing in either active or passive funds. Now, we’ll look a bit into the details of how you even choose a fund — like, where do you even look at? Everyone would claim their funds are the best, but how can you discern between reality and marketing feats?

Actively Managed Funds: The Pursuit of Alpha

Actively managed funds are led by professional fund managers who actively research, analyze and select individual securities with the goal of outperforming a benchmark index. These managers make investment decisions based on their expertise, market insights, and prevailing economic conditions. The aim of active management is to generate alpha, which represents the excess return earned above the benchmark.

Passively managed funds, often referred to as index funds or exchange-traded funds (ETFs), aim to replicate the performance of a specific market index, such as the S&P 500. These funds don’t rely on individual stock selection but instead aim to match the returns of the chosen index by holding the same or a representative set of securities in the same proportions.

Making an Informed Choice

The decision between actively managed and passively managed funds should be based on a thorough understanding of individual investment goals, risk tolerance, and time horizon.

1. Diversification:


Both active and passive funds offer diversification benefits, but the approach differs. Passive funds provide broad market exposure, while active funds rely on a manager’s ability to select a diversified portfolio.

If your main concern is diversification, on the basic level, what you can do is look at the percentage of assets that makes up the portfolio. You don’t want to have a mix of assets that are mostly highly volatile, nor do you want it to be too dormant. You’ll also want to make sure that the portfolio is not too heavy on one particular industry (unless that is the whole purpose of the fund, e.g., tech funds).

How can you find that? You can find the kind of assets involved in the fund by simply looking at the information provided by the fund issuers. For example, Bank ABC created a fund, which is Fund ABC. You can just search for it online and you’ll most likely find the information on said funds, and yes, they do disclose what kind of stocks or assets are in their funds — they have to, in fact.

Looking for industry can be easy, you just look into what companies are in the fund, look up what industry the company is in, and there you go… but how o you look for asset volatility? This one is a bit tricky, but what you can do is look for each asset’s variance to give you a glimpse of how volatile an asset is.

There are more ways to look at it as you dive in deeper, but as a beginner, those would suffice to give you a general idea of the fund’s constituents.


2. Cost Considerations:


Another thing that may come into consideration for most investors is the cost. Different funds charge different rates (but they’re usually nearly the same). Passively managed funds generally have lower fees, which can be especially important for long-term investors seeking to maximize returns over time.

If you want to look deeper, different funds will usually have different fee structures. For mutual funds, people would usually look into its expense ratio. In many cases, actively managed funds would have an expense ratio of around 1%, while passively managed funds would have an expense ratio of around 0.2%.

This expense ratio would be a percentage that they will charge annually on the amount of your investment. Say, you invested $100, an expense ratio of 1% would mean you’ll be charged $1 annually. Oh, and taking your money out before one year wouldn’t exempt you from the fee.

Some mutual funds also charge sales loads, which are fees paid to brokers or salespeople for selling the fund. There are two main types of sales loads: front-end loads (charged when you buy the fund) and back-end loads (charged when you sell the fund). These fees can further impact on your returns.

That is for mutual funds. Hedge funds, which is like mutual fund on steroids, would typically have the 2:20 system. What it means is that you’ll have to pay 2% annually of your investment value, and 20% of the excess returns (in relation to the benchmark).

For example, you invest $100 in a hedge fund. Over the year, they managed to grow it to $150. What you’ll have to pay is the 2% of that $100 that we spoke of, this one you’ll have to pay even if the fund flunked. Now, say, the benchmark grows at 20%, which means that if you invest in the benchmark, you’ll get around $120, but now your fund manages to get it up to $150, $30 more than the benchmark.

20% of that extra 30% (in this case the $150 — $120 = $30) will be their incentive fee. So, in the situation above, you’ll get $142 (considering the 2% and 20%).

For exchange-traded funds (ETFs), they also have expense ratios like mutual funds. However, depending on the kind of ETF, they tend to be lower — sometimes as low as 0.05%, but some can still charge up to 1% in expense ratio.

If you’re choosing between active or passive funds, you’ll have to consider the cost of investing in said funds, and whether it is worth it. For example, if you pay 0.5% in fee, but the fund’s growth is not impressive, you might just get an expensive one that could grow your money so much you forgot how expensive it was. Although, quick tips: expensive fees don’t always warrant good performance.


3. Expertise vs. Consistency:


Active management relies on the skills of fund managers, while passive management offers consistency by tracking an index. Investors must decide whether they trust a manager’s expertise or prefer a more predictable, benchmark-aligned approach.

Either way, you can look into the fund’s performance relative to the benchmark. Active or passive, if the fund consistently beats the benchmark, you might want to consider going for it. Just don’t rely too much on short-term performance, as it can be misleading. People would usually see if their gains were consistent through the period of 1 year, 3 years, 5 years, and 10 years period. Some would even go for more — some less.

To see how well each fund performs, you can visit the fund provider’s website, or you can go to Morningstar where you’ll have to just enter the fund name or ticker.

If you want to go a step further, you can also look at the fund’s Information ratio (IR) which essentially tells you how much of the fund’s movement is attributed to managerial skills, and how much of it is from hugging the benchmark. Put it like this — the market will move up and down based on the information available out there. Bad news, down. Good news, up.

How IR works is that the benchmark can be said to the movement of the masses, where most people stand, or sheeple if you feel like using that term. When investing in funds, you’re paying your fund manager, right? You don’t want the manager to perform just like everyone else, you want them to be an actual super-smart mathematician which they claim to be, and outperform everyone else. That is what IR tells you if your fund manager is actually really smart or nah.

For IR, the higher the better. If it’s less than or too close to 0, you might want to reconsider paying the manager. An active fund would usually require a higher IR ratio compared to passive funds.


4. Risk Assessment:


The next thing that you want to note when speaking of funds is the level of risk that it entails. Different funds are managed by different managers, and different funds are created for different purposes. Some can be riskier; some can be more stable.

To look into this, you’ll have to evaluate the fund’s volatility and risk-adjusted returns using metrics like standard deviation and Sharpe ratio. A higher Sharpe ratio usually indicates better risk-adjusted performance. It means that the return is worth the risk you’re taking.

In many cases, people would consider a Sharpe ratio of 1 and above as good, something around 3 and above is like wow, and below 1 are like, not so desirable (to put it nicely).

Bottom Line

There are actually more things to look at, but this would suffice from a general standpoint. Deciding between actively managed and passively managed funds depends on an individual’s investment objectives, risk tolerance, and market outlook. Some investors may prefer active management to potentially capture higher returns, while others may prioritize lower costs and consistent market exposure offered by passive funds.

You can also blend both approaches within a diversified portfolio. This can help harness the benefits of active management while reducing the overall portfolio’s costs and risks through passive investments.

We can’t tell you which one is better for you, and even between active and passive funds, there is no clear answer as to which style is better. Some fund managers are just better than their peers, regardless of the style they use. It would also depend on you, and how you want your investments to be, short-term, long-term, risky, stable, and more.

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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.

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