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.