The active vs. passive investment debate has gained considerable traction over the last five years or so. A big reason being the emergence of exchange traded funds (ETFs), a smart passive investment approach, as an alternative to mutual funds. A closer scrutiny on fees and their impact on net returns (i.e. end cash in an investor’s pocket) have also helped spark this debate.
Unbeknownst to many, a societal shift has firmly set in transferring the responsibility of retirement planning and saving from employers to employees (also known as “you”). With this in mind, a proactive and informed approach to retirement planning is a must for those looking to maintain or step-up their standard of living in retirement.
Future retirees’ investment strategy and day-to-day spending control are “1” and “1-A” when it comes to setting up the retirement you aspire to. Reasonable people will disagree one which comes first (I personally side with spending control).
Getting back to the title and with apologizes to the gifted students, as I like to do, let’s make sure we’re all clear on the basics.
As the name suggests, active investing involves the judgmental (some may prefer “strategic”) buying and selling of investments in an attempt to predict “winners” and “losers” (“timing the market” is another way to describe active investing).
Broadly speaking active investing is achieved in two ways 1) owing shares of individual companies or 2) purchasing units of a mutual fund which in-turn owns shares of companies (usually many companies in an attempt to diversify). To keep things simple, I’m ignoring fixed income investing (lending money and earning interest rather than buying ownership, such as bonds).
As the majority of individuals save for retirement using actively managed mutual funds, I’m going to focus there for the remainder of the post.
The Mutual Fund Leech – MER’s
The primary fee paid for mutual funds purchased at the big banks or similar institutions is calculated in the same way – as a percentage of the value of the mutual funds. The investment industry calls this fee the “management expense ratio” (MER) and it typically accounts for the lion’s share, if not all, of the total fee. The average MER in Canada is 2% but can be as high as 3% or as low 1% give-or-take (these fees are typically lower in the US). In a simple example, if your mutual funds return 5% and your MER is 3%, your net return is 2%.
Take care to understand the MER in any given mutual fund as these fees are taken even if your mutual fund declines in value. Over the long run a 1% to 3% MER will have a massive impact on your holdings, so it’s important you receive good value (by way of strong fund management and relative market performance) for the embedded MER fees you pay.
Just like active mutual fund investing, passive investing involves investing in funds of pooled money (such as EFT’s) which in-turn owns shares of companies. The meaningful similarities stop there.
The companies owned in the pool of funds are predetermined and held indefinitely (hence a “passive” approach) as opposed to “actively” attempting to sort out “winning” and “losing” investments on a day-to-day basis.
The most popular form of passive investing, and the sole focus from here on, is broad market index investing via ETF’s. This basically means the investor owns a teeny-tiny fraction of every company trading on a major stock exchange(s). North Americans will be familiar with the TSX (Canada) and S&P 500 (US) indexes, home of essentially all the value of North American public companies.
Look at it this way – when a newscaster points out the TSX or S&P is up or down by such-and-such – well so are your investments held in your broad market index fund or EFT.
The other important difference is of course fees. The method for passive MER’s range from 0.5% on the high end to 0.1% on the low end in most ETF’s.
To start building the case for passive investing, this difference of a percentage point or two in fees over the course of 30+ years of retirement savings will put tens of thousands of dollars in one’s pocket and hundreds of thousands in a lot of cases. This ignores investment performance which I’m about to hit on.
Active vs. Passive Investing – the Facts
As mentioned, the most popular form of retirement saving is through actively managed mutual funds. However, an increasing number of investors (albeit still a vast minority) are turning to broad market index investing using ETF’s – and for good reason. Consider these points:
- When factoring the differential in fees, over the very long term of 20+ years, being generous less than 10% of mutual funds outperform the passive broad market index strategy. On the surface 20 years may seem like a long-time; but really is not when accepting we should be saving for retirement from day 1 of what is a 40 year working career for most.
- What are the odds you’ll be the smarty-pants that identifies an investment advisor who is going to put you in the ~ 10% of mutual funds who will beat the index? Well with reference to the above…about 10%. Talk about rolling the dice on your retirement.
- The central argument put forth by active mutual fund advocates is that broad market passive strategies do not serve investors well in falling markets. Looked at in isolation this is damming – as explained investor’s returns will mirror the ups and downs of the stock market (excluding fees). However, empirical data from the 2008/2009 stock market crash is clear on the fact that when factoring fees, active strategies fared no better than passive. The real winners were the investment industry players who raked up heightened sales commissions with all the panicked buying and selling.
- Still not convinced passive is the way to go? Read John Bogle’s book The Little Book of Common Sense Investing. John hammers home all of the above and deepens the argument by, amongst other things, getting into the negative impact of secondary fees (beyond the MER I’ve focused on) of mutual funds and tax inefficiency inherent in most actively managed products.
My Passive Investment Portfolio
To add some credibility, I have, as they say, serious “skin-in-the-game.” My entire do-it-yourself (DIY) retirement portfolio is made up of low-cost broad market index funds. Each is a Vanguard product and the MERs are ~ 0.10%. Portfolio as follows:
30% Canadian equity, ticker symbol VAB:CA
30% US equity, ticker symbol VTI
30% International equity, ticker symbol VXUS
10% Canadian fixed income (virtually all Canadian government bonds), ticker symbol VAB:CA
With this mix I’m invested in a significant portion of public companies worldwide. I’ve essentially hitched my wagon to the returns of the world wide stock market.
Bought into the passive argument but not ready for DIY investing?
Invest with an advisor who charge as a percentage of investment, normally referred to as a portfolio manager (PM), and insist they invest in passive low-cost broad market index funds.
The going rate for PM’s 1% of assets which means your total cost will be 1% + the MER on your funds which shouldn’t be much more than the 0.10% I’m paying. On balance this will still leave you better off than mutual funds charging 2%.
Another option is to try investing with a robo-advisor. Read all about it in a past post here. In a nutshell, robo advisors employ passive broad market index investing for an all-in fee of ~0.5%.
Take control of your retirement and insist on passive broad market index investing. This introduction combined with further research should make its superiority clear – be that over mutual funds or other alternatives.
My Saturday night is wide open…I’d love to hear and respond to views on either side of the coin. Happy passive investing!
The author, Pat Kenney, is a Certified Professional Accountant. He has worked in public practice at a local boutique CPA firm in Mississauga for 9 years. He currently holds a senior management position.