If you read any reputable book on personal finance and investing, they almost always agree on one thing: for the vast majority of people, passive index investing is the way to go. Unfortunately, index funds are some of the least lucrative options for financial advisors to sell to you, creating an inherent conflict of interest. Fortunately for you however, self-directed passive index investing is now easier and cheaper than it has ever been.
Unfortunately most people who don’t have time or interest to read a book on the topic are also the ones who typically pay way too much for actively managed investment products, or even worse have a financial advisor who picks individual stocks for them. If you are in this situation, the good news is that you have the most to gain from switching!
What is the difference between a passive index fund and an actively managed fund?
| Passive Index Funds | Actively Managed Funds | |
|---|---|---|
| Goals | Track the performance of a market index, such as the S&P 500 (the largest 500 US stocks) or the TSX Composite (the largest 250 Canadian stocks) | Research and select individual stocks to form a portfolio that aims to outperform a particular benchmark index. |
| Costs and Fees | Very low. These funds don’t require any research analysts, and can operate more or less automatically. Because their composition does not change very often, they have minimal internal transaction costs. | High. Not only do these funds employ an army of highly paid financial analysts, they also typically have much higher turnover of stocks as they buy and sell based on company news and market events. This results in much higher internal transaction costs that are passed on to investors who own these funds. |
| Incentives for Financial Advisors | Low. These funds run on a low cost model, which does not allow for fat commissions or kickbacks to advisors who sell them. No wonder most financial advisors don’t like them! | High. Salespeople, sorry-financial advisors, need to make money too, right? Actively managed funds typically offer commissions to advisors that sell their products. Why do you really think they are recommending that new mutual fund for you? |
| Performance | By definition, index funds will never ‘beat the market’. They will, however perform consistently in line with their benchmark, less any management costs and fees. | Varies. Some funds may meet their goal of outperforming the market for short periods, but research shows that the majority of actively managed funds will underperform the index in any given year. Over a long period of time they almost always fall behind. |
So why should you switch to a passive index investment strategy? Here are a few reasons, and if you still don’t believe me then please go and research it for yourself.
Performance
Passive index funds outperform the vast majority of actively managed funds over time.
S&P Global, a large index tracking firm, provides a semi-annual SPIVA® scorecard (S&P Indices Versus Active Funds) comparing the performance of active and passive investment returns over various categories, geographies and time periods. Over the 10 years to 2021, 81% of actively managed Canadian equity funds underperformed their benchmark. The underperformance rate varies from 57% for Canadian small/mid-cap funds to 93% for US and Global equity funds, and this does vary from year to year. The odds are clear however, the investor who invests their money in passive index funds is more likely to outperform someone who invests in actively managed funds.
Costs and Fees
One of the major reasons for the underperformance of actively managed funds is the higher ongoing costs. A 2019 report by PWL Capital estimates that the weighted average Management Expense Ratio (MER) for passive funds in Canada was 0.28%, while the equivalent for active funds was 1.59%. That is a whopping 1.31% difference! This works out to more than one fifth of your returns in a fund that grows at 6% a year.
So even if an active fund is able to beat the market with their ‘secret sauce’ and stock picking, they would have to do so by more than 20% to allow their fee-paying investors to get the benefit. Good luck with that!
Tax efficiency
Because index funds have less turnover in their underlying holdings, they are more tax efficient for investors. This difference is most pronounced when the fund is held in a non-registered (taxable) account.
Simplicity and Transparency
If you liken stock-picking to finding a needle in a haystack, buying an index fund is like buying the whole haystack. It is easy to do, and you know that your returns will track the market regardless of what happens. You can also know exactly what your underlying holdings are at any point, and know that they don’t change very often.
Diversification
One of the golden rules of creating an investment portfolio is to be well diversified. Diversification reduces your portfolio risk and volatility for a given expected return. The more individual stocks you own, the better your risk-reward trade-off is going to be. Indexes typically hold hundreds, sometimes thousands of individual securities, providing inherently good diversification across a range of industries and markets.
Recommended by the Experts
You would be hard pressed to find any reputable expert (outside of the conflicted investment advisory business) who would disagree that passive index investing is the way to go for the vast majority of us.
There are plenty of experts who have weighed in on the matter however, including famed investor Warren Buffett, and numerous Nobel Laureates.
“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
– Warren Buffett, in his 2017 annual letter to Berkshire Hathaway Shareholders
“The most efficient way to diversify a stock portfolio is with a low fee index fund”
– Paul Samuelson, 1970 Nobel Prize in Economics
“Any pension fund manager who doesn’t have the vast majority-and I mean 70 percent to 80 percent of his or her portfolio-in passive investments is guilty of malfeasance, nonfeasance, or some other kind of bad feasance!”
– Merton Miller, 1990 Nobel Prize in Economics