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Fund Management - Active/ Passive

Executive Summary

If you’re truly interested in understanding investments, a cocktail party or coffee klatch probably isn’t the best source of information.

One of the most popular topics is whether you should utilize “active” or “passive” management. As we know, this decision - like all investment decisions - should not be made in isolation, and your investment strategy and other holdings are influential. However, if we limit the discussion to these two types of management with a real-world example, each has its own advantages and disadvantages.

Generally, passive management has lower fees than active management. A simplified view is to examine the differences between “passive” Exchange Traded Funds (ETFs) and “active” Mutual Funds (MFs).

What you need to know

Originally, Exchange Traded Funds mirrored an index like the TSX or the S&P 500, or a sub-index for a commodity (like gold, for example). Since the exchanges themselves were deciding the assets that comprised the index or sub-index, all the ETF had to do was follow their lead. There were no investment decisions or analyses to be done, and consequently, management fees were lower than those for mutual funds. Simply put, the ETF’s operating costs were lower.

Another difference is that ETFs are bought and sold, and priced throughout the day like an individual stock. Conversely, ETF manufacturers would create the product and then “let it run”, managing it passively.

Traditionally, mutual funds are managed actively. That is, the mandate of the fund provides guidelines for holdings, but the fund manager decides specifically what and when to increase or diminish holdings for sectors and individual stocks to achieve their return, risk and volatility goals.

For example, a Large Cap Dividend Mutual Fund is comprised of stocks with large capitalization that pay dividends. Investors can indirectly own over 100 major firms such as Scotiabank, Canadian Pacific and TransCanada inside a fund, and hire the fund manager to adjust the holdings continuously to achieve the best return. This is active management. It would be impractical and almost impossible for individual investors to own these stocks and manage their complex portfolio independently.

The Bottom Line

In the end, it’s not whether a particular fund is managed in a particular way; it’s whether or not you believe it will contribute positively to achieving your investment objectives.

Examining a fund’s mandate and alignment with your investment strategy is the starting and end point for decisions on the purchase of a fund.