Active funds vs passive funds

Retail investors often ask what is better, a passive fund or an active fund. With lots of market commentary about index funds, let’s take a look

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These days, a lot of column inches are dedicated to index fund, or passive, investing. On inspection, it is easy to see why. They have added a welcome element of simplicity into the investing equation. An index fund will aim to match its respective market. No more and no less.

Seal of approval

Index funds have been given the nod of approval by legendary investor Warren Buffett, in part due to the low-cost nature of the funds. Normally, these funds charge the investor a comparatively small fee, which is sometimes under 0.1%. Many investors see the natural diversity of the whole index as a benefit, too.

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Index funds were pioneered by Jack Bogle. He saw a need for retail investors to get close to mirroring the market, rather than stock picking via a mutual fund and potentially underperforming an index’s results. He wanted investors to reap the rewards of the markets, rather than see the profits being eaten up by financial elites.

Recently, there has been noise about how index investors could be creating a bubble. Leading this conversation is Michael Burry, of The Big Short fame. Burry has concerns that retail investors are buying funds without careful analysis of the underlying companies. He fears this could lead to the companies being valued on the same terms.

Setting aside Burry’s concerns, I wanted to juxtapose index funds with their natural competition for many retail investors’ cash: active funds.

As the name suggests, an active fund is a mutual fund that is being actively managed. For example, the manager of the fund might see a buying opportunity for tech stocks, and plough money into them, moving away from another area, like mining. In a turbulent market, they may even reduce their position in stocks and hold a cash reserve. In return for this active management, these funds usually charge higher fees.

A big bet

In 2008, Warren Buffett famously held a bet. He reckoned that over 10 years, an index fund would outperform a collection of hedge funds. He put his money where his mouth was, stumping up $1m, to go to the chosen charity of whoever the winner might be. Protégé Partners took up the bet and chose a portfolio of handpicked funds. Buffett’s choice won.

Eagle-eyed readers will note that in 2008, the markets tanked. The actively managed funds were able to adapt to the market conditions, while Buffett’s money sat riding the market storm. Buffett’s fund lost 37%, and Protégé’s lost only 24%. At the end of 2016, however, Buffett’s fund had returned just over 7% a year, to the 2.2% gained by Protégé.

Is there a right answer between choosing an active or passive fund? As always, it depends on your situation. But I think that for investors who are willing to stick it out over 10 years, an index fund is hard to beat.

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T Sligo has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

 

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