Investing and Saving
Though all investors are unique in terms of their beliefs, goals, preferences, and risk profiles, ultimately they all want to grow their hard-earned savings in order to achieve their financial goals.
When it comes to investing, there are two primary strategies that often come into play—passive investing and active investing. Which approach is better has been tirelessly debated for years, with devoted proponents on each side.
Our view is not that one is necessarily better than the other, but rather that each approach has its own set of potential benefits and limitations which can cater to different types of investors and their goals. Understanding the basics of these different styles of investing is important in helping you make informed decisions on how best to put your money to work.
What is passive investing?
Passive investing involves putting your money into funds that are designed to replicate an index, such as the S&P 500 or TSX Composite. This means that returns from a passive investment should closely match the returns of the underlying index it tracks.
Indexes can come in many different forms but all have predetermined rules around which securities are eligible for inclusion, how the weights will be determined, as well as how they’ll be periodically rebalanced back to target. For instance, the S&P 500 measures the performance of the 500 largest companies in the United States, with the biggest companies commanding greater weight and influence within it.
The idea behind passive investing is to match the performance of the index which is often a representation of a particular market (such as large US stocks in the case of the S&P 500). This approach typically involves purchasing index mutual funds or exchange-traded funds (ETFs).
Potential benefits of passive investing
- Low costs
- Passive funds typically carry lower management fees and transaction costs because they simply track a predetermined index. All else equal, lower costs lead to higher returns for an investor.
- Tax efficiency
- Passive funds tend to generate fewer taxable events due to less frequent trading. This can result in smaller taxable distributions to investors that hold passive funds outside of registered accounts.
- Consistent returns relative to index or ‘market’
- Passive funds deliver returns that closely match those of their underlying index, reducing opportunity for relative underperformance.
- Transparent
- Since indexes are rules-based and publish their underlying holdings, investors of passive funds have full transparency of the strategy and holdings of their investment.
Potential limitations of passive investing
- Lack of flexibility
- Passive funds are limited by the composition of the index they track and cannot adapt their holdings to changing market conditions in order to capitalize on short-term opportunities.
- Market risk
- Passive funds are exposed to the market risks of their underlying indexes and lack the ability to avoid or mitigate losses associated with downturns.
- No potential for outperformance
- By design, passive funds will not offer opportunities to outperform their index and tend to marginally underperform after fees.
What is active investing?
In contrast to passive investing, active management involves a hands-on approach where professional fund managers make investment decisions with the goal of outperforming an index. This relies upon a combination of research, analysis, forecasting, and professional judgment and experience of investment professionals who decide which securities to buy and sell along with the weightings to attribute to each within a portfolio.
Traditionally, mutual funds have often used active management in their strategies, but actively managed ETFs have become increasingly prominent as well.
Potential benefits of active management
- Flexibility
- Active managers have autonomy to manage the portfolio as they wish and to create strategies that can match a variety of different investor objectives and risk profiles.
- Professional oversight
- Management by a team of investment professionals can provide investors peace of mind and reassurance, particularly during market downturns.
- Potential outperformance
- Skilled managers can provide an opportunity to outperform in rising markets and protect downside in market downturns by making adjustments to the portfolio.
Potential limitations of active investing
- Higher costs
- Active management involves higher management fees to compensate the investment professionals.
- Potential for underperformance
- Active management relies upon the investment decisions of the management team, which are not guaranteed to outperform relative to an index, especially after higher fees are considered.
- Potentially less tax efficient
- Active management typically involves a greater rate of buying and selling securities within a fund, which can lead to an increase of taxable events. This can result in larger taxable distributions to investors that hold active funds outside of registered accounts.
| ↓ | Passive | Active |
|---|---|---|
| Management style | Hands-off, rules-based approach that closely mirrors the holdings of an index | Active decision making based on continuous analysis and research from a team of investment professionals |
| Cost | Fees are low and typically fall in a range of 0.05-0.25% | Fees are higher and tend to fall in a range of 0.5-1.2%(excluding trailing commissions) |
| Performance | Delivers returns that closely match the underlying index | Attempts to outperform, but may underperform a specific index |
| Tax efficiency (when invested outside of registered accounts) |
Tends to be more tax efficient as trading activity is typically less frequent | Tends to be less tax efficient as trading activity is typically more frequent |
| Risk management | Fully exposed to the underlying market risks of the index | Can potentially cushion market risks by making adjustments to the portfolio |
Final thoughts
Both passive and active investing have their merits and can play a role in an investor's portfolio. Passive investing offers low costs, tax efficiency and consistent returns relative to the market but lacks flexibility and potential for outperformance. On the other hand, active investing provides flexibility, the potential for higher returns, and professional management, but comes with higher costs and potential risk of underperformance and tax inefficiency.
Ultimately, the best approach depends on your financial goals, risk tolerance, and personal preferences. Many investors find a combination of both strategies offers a balanced and diversified approach to achieving their financial objectives. Understanding the basics of these strategies is a crucial first step in making informed decisions about how to best put your money to work. Whether you opt for a passive or active approach, or a combination of the two, aligning your investment strategy with your financial goals and taking a long-term approach is key to investing success.
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