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.