For the vast majority of investors, it makes sense to hold a diverse portfolio of investments.
But, unless you are willing to go out and individually pick 20 different securities yourself, it’s likely you will be relying on financial products like mutual funds and ETFs to accomplish this diversification.
What is the difference between the two, and how do active and passive management techniques factor in?
There are two common, useful tools that allow investors to obtain stakes in multiple assets, strategies, and companies:
- The modern mutual fund was born in 1924, and is an investment vehicle using a pool of money collected from many investors.
- Most mutual funds are actively managed by a professional portfolio manager, who is trying to beat the market using an investment strategy.
- Investors buy or sell their shares in a mutual fund directly from the fund provider.
Exchange Traded Funds (ETFs):
- The first successful ETF was in 1990, and it also serves as an investment vehicle using pooled money.
- Most ETFs are passively managed – meaning many are index funds that track the performance of a market index.
- Investors buy or sell their shares from other investors, similar to how stocks trade on the market.
Each investment product has gained considerable acceptance. ETFs have seen increased adoption in recent years, but mutual funds have been used in retirement plans such as 401(k)s for decades, and for now still have wider overall acceptance.
ACTIVE VS. PASSIVE MANAGEMENT
There are two competing strategies that are used by both mutual funds and ETFs: you can actively try to beat the market, or you can passively invest with the market.
- Purpose: Trying to beat the market
- How? A professional portfolio manager invests in strategies he/she thinks can beat the market.
- Example: Using analytical research, forecasts, and judgement to invest in specific stocks that will outperform the market.
- Typical fees: High
- Purpose: Match the market’s performance
- How? Simply tracking the performance of a market index
- Example: Tracking the S&P 500 index, automatically giving exposure to all the stocks in the index.
- Typical fees: Low
While both strategies can have success, the one that works best for an individual will depend on what they are trying to accomplish.