Mutual funds and exchange-traded funds (ETFs) come in two distinct streams:
- Actively managed. Here professional fund managers use their expertise and research to buy and sell investments for the fund. The fund managers may also aim to manage risk and adjust the fund’s holdings in response to market changes. The goal is to beat the market’s average return by making selective investment decisions.
- Index investing. Index investing is like setting your investment portfolio on cruise control. Index funds aim to match the performance of a specific market index. For example, they may closely track the holdings of a broad index like the S&P/TSX Composite Index or S&P 500 Index. Or, the fund may follow a more specialized index that focuses on a particular sector or region. The strategy involves minimal or even no buying and selling within the fund and often provides a lower-cost investment solution.
Which approach is right for you? In this article we’ll explore the pros and cons.
Myth buster: Are all mutual funds actively managed? Are all ETFs index funds? No. You will find mutual funds and ETFs in both streams. It’s all about choice.
Key takeaways
- Active management offers the chance to beat the market but often comes with higher costs and risks.
- Index investing is a ‘set-it-and-forget-it’ approach that's often cheaper and tax-efficient but won't outperform the market.
- The right choice depends on your investment goals, risk tolerance, and whether you believe the potential rewards of active management outweigh the risks and costs.
Potential to outperform: The fund managers aim to do better than a comparable index, giving you a chance at higher returns. The amount your fund outperforms is called ‘alpha.’
Expertise: Your money is in the hands of investment professionals who use their knowledge and experience to make informed decisions.
Flexibility: The fund managers can quickly adapt to changing market conditions. They can move into new areas of opportunity or exit positions that are no longer performing well.
Higher costs: You're paying for the expertise of the fund managers, so fees can be higher than an index investor may pay – although there may not be a big difference.
Risk of underperformance: There's no guarantee the fund manager will beat the market, and sometimes they might do worse.
Possible tax inefficiency: Frequent trading in pursuit of ‘alpha’ can lead to more taxes. For example, active funds must distribute realized capital gains to shareholders each year. These distributions are taxable if you are investing in a non-registered investment account. [Note: if you are investing in an RRSP, no taxes apply on your gains as long as they stay in your account. If you are investing in a TFSA, no taxes apply on gains, period.]
Lower costs: Without active managers to pay, these funds often have lower fees.
Market-level returns: If the index does well, so does your investment.
Tax efficiency: Less frequent trading means fewer realized capital gains. This can lower taxes for investors – again, depending on whether you hold the funds in a non-registered or registered account.
Your returns mirror the market: These funds aren't trying to outdo the market. Your fund returns will closely follow the index returns it tracks.
No defenses: In a market downturn, the value of your fund will go down with the index it tracks. There’s no one trying to cushion the fall when markets get choppy.
Limited to the index: You’re investing in whatever the index holds – even if some holdings aren't doing well. There’s no one trying to sift through market research and find better options for you.
Both styles have their strengths and drawbacks. The choice often depends on your goals, risk tolerance, timeline and beliefs about the market. You may even choose a combination of both to diversify your investment approach. It’s not necessarily an ‘either/or’ choice.
Where active management might work better
- In inefficient markets: In markets or asset classes where information is not as readily available, active managers may be able to find undervalued opportunities that can boost your returns. This includes international stocks in emerging markets and those of smaller U.S. companies.
- In uncertain or declining markets: When markets are choppy, active managers might quickly adjust the fund’s investments to limit declines or take advantage of short-term price movements.
- In niche markets: Specialized or niche sectors may benefit from the expertise of active managers who have a deeper understanding of the specific industry dynamics. For example, some investment firms have teams based in certain regions, like Asia. Having a local presence can help uncover opportunities that would be more likely to outperform a regional market index.
Where index investing may make more sense
- In efficient markets: In highly efficient markets, such as large-cap U.S. stocks, it can be challenging for active managers to consistently outperform the market after fees. In these cases, it may make more sense to ‘invest the index.’
- For greater simplicity and transparency: Investors who prefer a straightforward and transparent approach to investing might opt for index funds. The strategy is predictable and easy to understand.