Active vs. Passive Funds – Which is Best - Rodgers & Associates

Active vs. Passive Funds – Which is Best

Active fund management is where the portfolio is chosen by a manager or a team and then monitored and adjusted with the objective of beating a prede­ter­mined benchmark. Passive fund management is struc­tured to mirror an index or some other criteria with little or no changes. Which type of fund management is best?

Passive fund management has some important advan­tages from the start. Internal fund costs are generally lower. Tax costs are usually lower because turnover is less. Passive funds are quick to point out that histor­i­cally the average fund manager has failed to beat their benchmark.

It is also true that histor­i­cally about 25% of active fund managers have beaten their benchmark. We should not blindly ignore active fund managers. The problem for most investors is created by trying to pick which fund manager is going to outperform.

We believe that a properly diver­sified portfolio will contain both active and passive funds. When choosing actively managed funds, start by looking for a solid risk-adjusted perfor­mance history and verify that the manager and selection process that produced these results are still in place. Actively managed funds should be held in qualified accounts to minimize current income taxes. Passively managed funds should be held in taxable accounts.

The final ingre­dient is to have a disci­plined process for making changes to your portfolio. Managing a portfolio of mutual funds is not like managing stocks. You don’t need to be quick to sell to avoid a position sinking the ship. Changing a fund should be a thoughtful process otherwise you fall victim to chasing perfor­mance and the latest hot trend. The portfolio needs to maintain diver­si­fi­cation which means that something will be out of favor all the time. Your sell disci­pline needs to include measuring perfor­mance against peer groups, not just bench­marks.

A clearly defined investment strategy should be in place before you begin choosing funds. This strategy will include a clear buy and sell disci­pline. After­wards you can choose from the entire universe of active and passive funds to build your portfolio.