Active or passive investment: it’s your choice

The Oxford World English Dictionary defines the word hubris as an excess of pride or arrogance. Mr. Money would define hubris as an overconfidence in an individual’s ability to make consistently good investments. Herein lies the fundamental difference between passive and active investment management.

The Oxford World English Dictionary defines the word hubris as an excess of pride or arrogance.

Mr. Money would define hubris as an overconfidence in an individual’s ability to make consistently good investments. Herein lies the fundamental difference between passive and active investment management.

The mutual fund universe that most Canadians are exposed to has a multitude of offerings, from money market to balanced and equity funds.

Most investors view the difference between these funds as one of personal management and investment focus, such as growth versus value stocks, but miss one potential key difference — whether the fund is passively or actively managed.

What do these terms mean?

First, active management is the idea that the people managing your investments pick and choose from amongst the best of the best investments offered in the market place, based on their investment knowledge, training and experience in an effort to earn superior returns.

In other words, active managers are effectively in the business of trying to pick which teams will make it to the Stanley Cup finals.

Those teams that do can expect to earn more money from ticket and souvenir sales, and thus their owners will make more money.

In contrast, passive management’s focus is not on who has a higher potential to make it to the Stanley Cup, but rather on finding which leagues (football, basketball or hockey) will perform better, and thus make the majority of investors money.

In the world of investment management, choosing the best investments can potentially earn investors a higher return compared to everyone else. However, these investors start from the point of accepting a higher cost to achieving higher returns.

Typically, an actively managed fund will charge investors a management expense ratio of between two and 2.5 per cent. In other words, before you, or Mr. Money, have earned a dime, you have to make up for the higher MER.

Passively managed funds, in comparison, have lower MERs, typically ranging from one to 1.5 per cent.

The lower costs are the result of lower investment research expenses and lower transaction costs. After all, if your goal is to only find the best league, and not the best teams in the league, your costs will be lower.

This is not to say that actively managed funds are bad generally or that passively managed funds are always the right choice. There are, in fact, a broader range of considerations when choosing between an active or passive investment strategy.

First, passively managed funds are subject to “herd effects.” That is, if everyone decides that the entire league is not performing (lower returns), you will suffer lower returns despite having lower management expenses.

In contrast, actively managed funds that have returns on investment that are unusually high in the short run can suffer from what statisticians refer to as “reversion to the mean.” Remember what we learned in grade school science class: what goes up must, by virtue of gravity, go down. The same is true of high-flying, actively managed mutual funds.

Tracking error is an issue that passive investors must take into account. Tracking error is the idea that passive mangers, while striving to choose the best league to play in, will never quite get the same returns.

For example, a passively managed mutual fund might return 5.5 per cent but the market, such as the Toronto Stock Exchange, might return six per cent. The difference, a half per cent, is tracking error and should be considered when comparing an active and a passively managed fund, effectively reducing the cost advantage of passively managed funds.

Choosing an investment approach that fits best with your goals may simply be a matter of having a range of mutual fund investments that emphasize both active and passive management styles, because in the final analysis, you are in control of your financial destiny.

Easy Money is written by Patrick O’Meara, an instructor at Red Deer College’s Donald School of Business. He can be contacted at Patrick.O’Meara@rdc.ab.ca.

Get local stories you won't find anywhere else right to your inbox.
Sign up here

Just Posted

A woman walks through Toronto’s financial district on Monday, July 30, 2018. A new poll suggests most Canadians believe there’s still a long way to go to achieve gender equality in this country. THE CANADIAN PRESS/Graeme Roy
Canadians, especially women, say gender equality not achieved in Canada: Poll

63 per cent said equality between men and women has not been achieved

FILE - In this March 3, 2021, file photo, anti-coup protesters run as one of them discharges a fire extinguisher to counter the impact of tear gas fired by riot policemen in Yangon, Myanmar. The escalation of violence in Myanmar as authorities crack down on protests against the Feb. 1 coup is adding to pressure for more sanctions against the junta, as countries struggle over how to best confront military leaders inured to global condemnation. (AP Photo/File)
Escalating violence raises pressure for Myanmar sanctions

More shootings were reported over the weekend

A moth-killing drone hovers over crops in a green house in Monster, Netherlands, Thursday, Feb. 25, 2021. A Dutch startup is using drones to kill moths in midair as a way of protecting valuable crops in greenhouses that are damaged by caterpillars. PATS Indoor Drone Solutions emerged from the work of a group of students looking for ways to kill mosquitos in their dorm rooms. The drones themselves are very basic, but they are steered by smart technology and special cameras that scan the airspace in greenhouses. When the cameras detect a moth, a drone is set on a collision course with the bug, destroying the bug with its rotors. (AP Photo/Mike Corder)
Drones vs hungry moths: Dutch use hi-tech to protect crops

Drones instantly kill the moths by flying into them

Health-care worker Jenne Saunders prepares a dose of the COVID-19 vaccine at the Palais de Congress site as Quebec begins mass vaccinations based on age across the province on March 1, 2021 in Montreal. THE CANADIAN PRESS/Ryan Remiorz
Canada set to receive more than 910,000 doses of COVID-19 vaccines this week

Federal government looks for vaccine-makers to finalize delivery of eight million doses by March 31

Statistics Canada’s offices at Tunny’s Pasture in Ottawa are shown on Friday, March 8, 2019. Newly released documents show Statistics Canada considered delaying this year’s census until 2022 over pandemic-related concerns. THE CANADIAN PRESS/Justin Tang
Statistics Canada considered delaying this year’s census to 2022 due to pandemic

A census takes seven years between the start of planning to the release of data

Ben King scores for the Red Deer Rebels during the third period of a Western Hockey League game against the Calgary Hitmen at the Westerner Park Centrium Saturday. (Photo by Rob Wallator/Red Deer Rebels)
Rebels complete comeback to pick up first win of season

Rebels 3 Hitmen 2 (OT) The Red Deer Rebels were able to… Continue reading

Hamilton Forge FC’s Giuliano Frano (8) heads the ball against CD Olimpia’s Jorge Benguche (9) during Scotiabank CONCACAF League 2019 second half soccer action in Hamilton, Ont., Thursday, Aug. 22, 2019. Forge FC owner Bob Young says the Canadian Premier League champions will be playing the Canadian Championship final against Toronto FC at a disadvantage. THE CANADIAN PRESS/Peter Power
Forge FC owner upset at Canada Soccer’s timing of Canadian Championship final

Winner of Canadian Championship final earns a berth in the Scotiabank CONCACAF Champions League

Team Wild Card Two skip Kevin Koe reacts to his shot as he plays Team Newfoundland and Labrador at the Brier in Calgary, Alta., on March 6, 2021. THE CANADIAN PRESS/Jeff McIntosh
Wild Card Two’s Koe beats Gushue 9-7 to hand defending champs first loss at the Brier

Gushue was a tad heavy with his final draw and Koe picked it out for the victory

(Photo by THE CANADIAN PRESS)
No regrets: Grammy-nominated DJ Jayda G on choosing beats over sciences career

TORONTO — House music producer Jayda G knows a thing or two… Continue reading

This image provided by Harpo Productions shows Prince Harry, left, and Meghan, Duchess of Sussex, speaking about expecting their second child during an interview with Oprah Winfrey. “Oprah with Meghan and Harry: A CBS Primetime Special” airs March 7 as a two-hour exclusive primetime special on the CBS Television Network. (Joe Pugliese/Harpo Productions via AP)
UK royals absorb shock of revealing Harry, Meghan interview

Anti-monarchy group Republic said the interview gave a clearer picture of what the royal family is like

Minister of National Defence Harjit Sajjan takes part in a year-end interview with The Canadian Press at National Defence Headquarters in Ottawa on December 17, 2020. THE CANADIAN PRESS/Sean Kilpatrick
Conservatives to call top Sajjan, Trudeau aides to testify on Vance allegations

OTTAWA — The federal Conservatives plan to summon two senior Liberal aides… Continue reading

Elvira D'Angelo, 92, waits to receive her COVID-19 vaccination shot at a clinic in Montreal, Sunday, March 7, 2021, as the COVID-19 pandemic continues in Canada and around the world. THE CANADIAN PRESS/Graham Hughes
‘It’s been a good week’: Tam hopeful on vaccines as pandemic anniversary nears

Several provinces were preparing to loosen COVID-19 restrictions on Sunday, as Canada’s… Continue reading

Mount Pearl Senior High in Mount Pearl, N.L., remains closed on Wednesday, March 3, 2021. The provincial health authority says there were 185 cases at 22 schools, including 145 infections among staff and students of one high school in Mount Pearl that was an early epicentre of the outbreak. THE CANADIAN PRESS/Paul Daly
In Newfoundland and Labrador, three ingredients made for explosive COVID-19 outbreak

ST. JOHN’S, N.L. — With her classes, three part-time jobs and a… Continue reading

A passenger places a tag on luggage at the departure terminal at Toronto Pearson Airport, in Mississauga, Ont., Friday, May 24, 2019. The economic and life disruption caused by the COVID-19 pandemic has prompted many recent immigrants to leave Canada and return to their countries of origin, where they have more social and familial connections. THE CANADIAN PRESS/Chris Young
COVID-19 pandemic prompts recent newcomers to leave Canada for their home countries

OTTAWA — The economic and life disruption caused by the COVID-19 pandemic… Continue reading

Most Read