Knowing whether you prefer an active or passive approach to investing can help you make the investing decisions that are right for you. The first step is learning what an index is and how index funds work.
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What is an index?
When you hear people say the market is “up” or “down,” they are generally referring to how an index is performing that day. An index is a collection of securities or other assets that are meant to represent the performance of an economic sector or portion of the market, in reference to a point in time. Indices can be broad or narrow in focus.
Some examples of indices and what they represent include:
- S&P 500 – The U.S. equities market. This index contains stocks of 500 large companies with common shares listed on the New York Stock Exchange or the NASDAQ Stock Market.
- S&P/TSX Composite Index – The Canadian equities market. This index contains stocks of the largest companies on the Toronto Stock Exchange.
- FTSE TMX Canada Universe Bond Index – The Canadian investment grade fixed income market.
- Dow Jones Industrial Average – The Dow Jones Industrial Average, or the Dow, is a stock market index of 30 major companies listed on exchanges in the United States.
These indices give investors a general idea of whether trades within these sectors or markets are experiencing an upward or downward momentum. Many index providers publish a description of how their indices are put together on their websites, so investors can better determine if an index’s focus matches their investment goals.
How do index funds work?
Index funds are a way to invest in the same companies that are tracked by a particular index, without having to individually purchase each stock. Index funds aim to follow or mimic the performance of a specific index. The value of an index fund will typically go up or down as the index goes up or down in market value. Index funds are generally sold in the form of mutual funds or exchange-traded funds (ETFs).
An advantage of investing in index funds is that they offer the opportunity to diversify your portfolio across several different securities, like stocks or bonds, through a single investment. They also tend to involve lower costs than other types of funds that are actively managed day-to-day. However, one downside is that because index funds simply replicate the performance of an index, there is less opportunity to respond to market swings by changing the composition of the fund.
Some funds replicate an index by investing in each security that makes up the index. Other funds try to replicate the index by only buying a sample of securities with the same characteristics as securities within the index.
Additionally, some index funds track their index with a multiplier effect, by providing returns equal to two times the returns of the underlying index. Others track their index inversely, so when the index goes up, the index fund’s value goes down, and vice versa. These types of funds tend to make extensive use of derivatives, and their potential returns can be quite volatile. The prospectuses of these types of index funds generally disclose that the funds may not be appropriate for long-term investing. Before investing in a fund, check how it is tracked and what kind of index it is tracking.
There are many different types of exchange-traded funds (ETFs), including index ETFs. Some ETFs are actively managed, and others might track specific types of assets such as commodities or currencies. The type of management strategy used by the fund manager will affect its fees and how its performance is tracked.
What is passive investing?
Tracking the performance of an index is an example of a passive investment strategy. A passive investing approach aims to match the average market returns, rather than attempting to beat it. This means that your investments would typically mimic the performance of the market on a given day.
Passive investors believe it’s hard to beat the market with active trading, especially over the long term. Instead, they try to match market performance with a passive management approach. Passive strategies generally involve buying a portfolio of securities in order to track the performance of a benchmark or investment model. For example, funds indexed to the S&P/TSX Composite Index, Dow Jones Industrial Average, or the S&P 500. Fees could be lower with this strategy. A fund that uses a passive strategy is only modified if there is a change in the benchmark or investment model.
Funds that use passive investment strategies generally have lower costs than funds that use active investment strategies, because the passive fund’s portfolio manager doesn’t have to do as much research or make as many investment decisions. This also means that passive investing tends to have lower fees than an active investing approach. As a result, passive strategies can often outperform active strategies, especially when the costs of managing funds or making trades are taken into consideration.
Comparing your rate of return to that of an index is one step involved in tracking your investing returns. Checking in on how your portfolio is performing is something you can do annually or a few times a year, depending on your goals.
What is active investing?
In contrast to the more hands-off approach of passive investing, an active investing approach is typically very hands-on. It involves making frequent investing decisions to modify a portfolio. Active investing could be done by the manager of a portfolio or fund, or by an individual investor managing their own investments.
Active investing typically involves more frequent buying and selling of investments, with the goal of beating the market. Under an active management approach, success is measured by comparing a fund or portfolio’s returns to a relevant benchmark.
For example, the performance of an actively managed Canadian equity mutual fund could be measured against the S&P/TSX Composite Index, the benchmark index for the Canadian market. Active investors attempt to gain more than the benchmark index when the market is up and to lose less when the market is down.
Active investors managing a specific portfolio or fund typically manage mutual funds or exchange-traded funds (ETFs). This can also involve managing portfolios which include an array of stocks, bonds, or other investments. Actively managing a portfolio involves performing analysis of the different assets included in the funds, and making informed decisions as to when to buy or sell investments in the portfolio.
Individual investors who use an active investing approach are also more hands-on in the management of their personal portfolios. They devote time to analyzing different factors that affect the price of investments. This includes evaluating companies when buying stock, monitoring stock performance, and understanding companies’ financial statements. Active investors typically try to take advantage of fluctuations in the stock market to buy and sell at an ideal price for their investing goals.
If you’re trying an active investing approach on your own, be aware of the risks of overconfidence. Overconfidence can cause someone to over-estimate their own skills and experience, and believe they are outperforming other investors when in reality they may not be. You can keep overconfidence in check by doing your homework before making investing decisions, and ensuring you are making informed choices.
Can you be both active and passive investor?
How to balance active and passive investing depends on your investing personality. They both have unique benefits. Whether you’re investing on your own or working with a financial adviser, you can choose either approach, or you can do a combination of both. In fact, many advisers will recommend a blend of active and passive styles.
The choice of investing style really depends on your investment goals and what matters to you as an investor. Determine your investing personality.
Summary
- An index is a collection of securities or other assets that are meant to represent the performance of an economic sector or portion of the market, in reference to a point in time.
- Index funds aim to follow or mimic the performance of a specific index.
- A passive investment strategy tracks the performance of an index aiming to match the average market returns.
- An active investment strategy typically involves more frequent buying and selling of investments, with the goal of beating the market.
- Many advisers will recommend having a blend of active and passive styles.
