There are two main approaches to investment fund construction: active and passive. Let’s look at the essential features of each.
Active management involves researching and selecting individual securities in a fund, according to a portfolio manager’s particular investment approach, with the aim of outperforming that benchmark.
For example, a portfolio manager for a Canadian equity mutual fund will likely use the S&P/TSX Composite Index as the benchmark. The fund manager’s analysis may suggest that the consumer staples sector is likely to perform extremely well over the next year, so to capture that anticipated outperformance, the manager will give more weight (i.e., invest more of the fund’s assets) to consumer staples stocks in his or her mutual fund, relative to the benchmark weighting.
All else being equal, if consumer staples stocks perform as expected, the fund will generate a higher return than the index.
The fund manager also gives less weight – or no weight at all – to stocks or sectors he or she expects will perform poorly.
The goal of most active managers, then, is to gain more than the benchmark in good times, and lose less than the benchmark during downturns.
It’s important to note that in some cases a fund manager’s primary aim may not be to beat the benchmark’s returns. For instance, his or her goal may be to create a fund that returns about as much as the benchmark, but with less volatility than the index, since some investors are more concerned about having a smooth ride than achieving outsized returns.
The passive approach to investing (most typically, exchange-traded funds) seeks to construct a portfolio that replicates a benchmark index, such as the S&P/TSX Composite Index or the S&P 500 Index. This means buying every stock on the reference index – and in the same proportion.
Think of a company like Apple, a multi-billion-dollar business that comprises a large proportion – relative to other stocks – of the overall value of the S&P 500 Index. A passive manager will be sure to buy an amount of Apple stock that reflects its relative weight on the index. He or she will do the same for all other stocks on the S&P 500 Index.
Because the passive manager is replicating a ready-made template, rather than trying to add value through in-depth analysis, fees for passively managed funds are significantly lower than those for active funds.
While active and passive investing are very different, and often presented as competing styles, both have a place in the portfolios of all types of investors.