Understanding Active vs. Passive Mutual Funds

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This month, I want to discuss active vs. passive mutual funds and strategies to use incorporating both in your investment plan. Most 401(k) plans have a mutual fund lineup as a part of their investing option. In fact, some plans have three investing options; target date funds, mutual funds, and a self-directed brokerage account. Within the mutual fund options, plans may have all index funds (passively managed funds), actively managed funds or a combination of both. This article will discuss the differences between active and passive funds.

In general, a mutual fund is a collection of stocks, or bonds, combined to achieve the objectives of the fund. These types of funds (unlike exchange traded funds) cannot be traded intraday and are priced at the end of each trading day. There are many different sectors and objectives of mutual funds such as, large company growth, large value, small/mid-cap, global, international, short- to long-term bonds, and many others. A passive mutual fund, also called an index fund, uses an algorithm-based program to determine the underlying stocks’ relative position or weighting in the fund. There may be a manager to oversee the fund but this manager is not trading the underlying stocks that comprise the fund. A passive fund’s objective is to mirror the index to which it is tied, therefore an index fund will never out-perform its index. This type of fund also has a very low operating cost as there are little trading costs and underlying expenses associated with running this type of fund. A good analogy of this is if you throw a large fishing net from a boat, you will most likely pull in a lot of fish, but in addition, you may haul up a hubcap, plastic bags and other ocean junk. Within an index fund (passive mutual fund) are all the stocks that comprise it – good and bad – without the ability to manipulate the holdings within the fund. An example of how many stocks could be in an index fund is the total US market index fund. This type of fund has about 3400 stocks in it representing the entire US stock market.

On the other hand, for an active fund, the underlying stocks are bought and sold by a manger or multiple managers. This is done exclusively to try and beat the benchmark or index performance the active fund is tied to. There are trading costs (paying the manager, advertising costs, etc.) associated with this fund, so the operating expense ratio is higher than its passive fund partner. The number of stocks in an active fund is much smaller than in a passive fund. A large cap growth fund, for example will have about 70 stocks in it. The managers have the benefit of employed analysts and together they figure out when to buy and sell stocks, providing the potential to beat index funds’ performance by a great degree.

If your 401(k) has a choice and offers both active and passive mutual funds, a good strategy is to incorporate both in your investment philosophy. Potentially, you can take advantage of out- performing the index by utilizing active funds with a portion of your assets while also employing low cost index funds to mirror an overall index with a separate portion of your assets. There are pros and cons to both so having a mixture of them in your allocation make sense.

As always, you can contact Flight Line Financial (flightlinefinancial.com, 844- FLIGHTLINE) with any your questions on this subject or any questions on the topic of finance.

SOURCEAero Crew News, November 2018
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Glenn Nevola
Current airline captain and also financial advisor specializing in providing financial assistance to fellow airline pilots in their pre and post retirement planning. Glenn Nevola has been an airline pilot since 1986 where his career started with People Express Airlines, which merged with Continental Airlines in 1987 and was then merged with United Airlines in 2010. He is currently based in Newark as a 737 captain. In addition to being a pilot, he operated the financial arm of a real estate firm that purchased, renovated, rented, marketed, bundled and sold to investors over a 12-year span. He was personally responsible for over 300 closing during that timeframe. More recently he was a former financial advisor with Morgan Stanley in NYC where he acquired his Series 7 and Series 66 licenses. He brought over to the firm a concept and business model that would assist retiring airline pilots with post - retirement wealth management. This was, in part, augmented by the fact the mandatory retirement age was recently changed from age 60 to age 65 for commercial airline pilots. When Morgan Stanley hired him, the oldest of these pilots were then approximately 63 years of age. His unique position of living in both worlds – flying and finance - provided him the ability to market to his niche in direct target marketing from one of their own. He also has skin in the game, as he is a pilot, who participates in the retirement plans on which he advises and as such is in similar models as many of his clients. As time went on at Morgan Stanley a decision was made, based on many factors such as compliance restrictions, inability to market and assist younger pilots with their desire for 401(k) management and general restrictions on building out the business model, to split off and create his own financial services firm, Flight Line Financial, LLC (FLF) – a registered investment advisor based in NJ. FLF is also licensed in NJ for insurance enabling the firm to provide annuity counseling. This created a win - win scenario for further growth by allowing FLF to focus on 2 distinct groups of pilots – younger pilots, less than age 59 ½ and older pilots over age 59 ½. For the younger group, FLF provides asset allocation strategies incorporating diversification, dollar cost averaging and rebalancing options to pilots for a flat annual fee. Also discussed with this group includes topics such as Roth vs. non-Roth, 529’s, max contribution limits, 415 (c) limits, spousal accounts and other general financial topics. For the older pilot group, FLF has affiliated with a leading wall street firm for post-retirement financial planning. Wealth management services provided include many aspects such as creation of post retirement financial distribution plan, trust and estate planning, diversification, allocation, hedged equities, bond structuring, long term care, etc. The firm FLF is affiliated with has been in the wealth management business since the 1970’s and manages over $2 billion in assets from individual investors. Glenn has the unique position of living in both worlds – flying and finance. He interacts with his target market every time he is at the airport or on a trip. In numerous businesses, owners pay substantially for leads in their specific target market, such as mailing lists, calling lists, email lists, etc. Additionally, servicing the younger pilots creates pipelines for future rollovers. Currently FLF manages approximately $250 million in assets across approximately 200 clients.

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