What you should know about the active vs. passive fund debate

Financial Planning

According to Strategas Securities, 62% of actively managed large-cap “core” funds (that buy a mix of growth and value stocks) outperformed the stock market as a whole in 2022. That’s notable, because in most years, passively managed funds that mimic market indexes tend to do better than their actively managed counterparts. Does this mean you should invest only in index funds? Not exactly.

Defining Terms

Passive, or index, funds generally strive to track the performance of a particular market index, such as the S&P 500, Russell 2000 (smaller-cap U.S. stocks) or FTSE All-World Index (foreign stocks). Typically, they buy and hold all, or a representative sampling, of their chosen index’s securities and sell only to mirror changes in the index. Because trading is kept to a minimum, these funds usually are tax efficient. And their costs are low because they rely on a formula or algorithm rather than labor-intensive research and monitoring of individual stocks.

Active funds, in contrast, rely on rigorous analysis to evaluate individual securities and build portfolios that attempt to beat market indexes, reduce risk or achieve other goals. Because these funds often try to maximize profits by selling when investment objectives dictate, they tend to  be less tax efficient than index funds. Their need for expert analysts to select securities means that expenses generally are higher.

Why both styles are "active"

It’s important to understand that purely passive investing doesn’t really exist. Short of buying every security in the world, all investment portfolio choices are “active” to some extent. For example, if you choose the “passive” strategy of investing in an S&P 500 index fund, you’ve made an active decision to limit your investment to the U.S. large-cap stocks contained in that index. But they’re only a small fraction of the securities available in the United States and foreign markets.

Passive investing supporters often point to the fact that the majority of actively managed large-cap equity funds underperform their benchmark index over the long term. The semi-annual S&P Indices Versus Active (SPIVA) scorecard confirms that 89% of actively managed funds lag the S&P 500 index over a 15-year period (as  of June 30, 2022). In part, this  is because these funds charge higher expenses. 

However, some actively managed funds in other categories, such as bonds and small-cap equities, regularly beat their indexes. And even some actively managed What you should know about the active vs. passive fund debate large-cap stock funds outpace their benchmarks, particularly over the short term. The trouble is finding those active funds that beat  indexes — and keep doing so in different markets.

You don't have to choose

If you’re generally a hands-off investor who wants your portfolio’s returns to reflect that of major market indexes, you may want to buy one or more low-expense index funds. Fortunately, most investors don’t actually have to choose between active and passive investing. You can hold a variety of investment types — including active and passive funds, as well as individual securities — in a diversified portfolio. Just make sure your overall portfolio reflects your long-term goals, financial resources, investment knowledge and risk tolerance. Risk tolerance is especially important because any investment has the potential to dramatically fall in value and could even lose money over the long-term. Discuss your options with 
your Lenox Advisor.

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