Ever since the first index fund was created, the debate between active versus passive management has been nothing less than heated.

Active management is simply an attempt to "beat the market" as measured by a particular benchmark or index. For example, an investor might buy or sell certain stocks to try to get better returns than the stock market indices such as the TSX, S&P 500 or the Dow Jones Industrial Average (DJIA).

The aim of active fund management — after fees are paid — is to outperform the index for a particular fund (or to outperform other fund managers they may be competing against). Prevailing market trends, the economy, political and other current events, and company-specific factors (such as earnings growth) all affect an active manager's decisions.

Mutual funds generally fall into the active management category because, in most cases, the fund managers select the stocks rather than passively buying an index. However, many mutual fund managers are closet indexers and are not worth the fees they charge, and most mutual funds are so large they are not nimble enough to respond quickly to market fluctuations. For these reasons, most mutual funds fail to beat the indexes. Only select mutual funds are worthwhile investments—make sure you choose carefully.

Passive management is more commonly called indexing. Indexing is an investment management approach based on purchasing exactly the same stocks and bonds, in the same proportions, as an index through Exchange Traded Funds (ETFs) and other index funds. This management style is considered passive because portfolio managers don't make decisions about which individual components to buy and sell; they simply invest in funds that copy the indices.

Which approach works best?

Proponents of each believe their approach is the right one, the one that has the potential to generate the greatest amount of return over the long term. The two camps see the investment world in very different ways, both making logical and passionate arguments for their viewpoint.

Passive managers generally believe that it is difficult to beat the market. Therefore, they essentially offer performance that closely matches an index for those investors who are unwilling to assume the risks of active management.

Active managers believe the market can be beaten. While they can't beat it all the time, many active managers do believe there are certain irregularities in the market that can be taken into consideration to achieve potentially higher returns.

Active management: Advantages
Expert analysis — seasoned money managers make informed decisions based on experience, judgment, and prevailing market trends.
Possibility of higher-than-index returns — managers aim to beat the performance of the index.
Defensive measures — managers can make changes if they believe the market may take a downturn.

Active management: Disadvantages
Higher fees and operating expenses.
Mistakes may happen — there is always the risk that managers may make unwise choices on behalf of investors, which could reduce returns.
Style issues may interfere with performance — At any given time, a manager's style may be in or out of favour with the market, which could reduce returns.

Passive management: Advantages
Low operating expenses.
No action required — There is no decision-making required by the manager or the investor.

Passive management: Disadvantages
Performance is dictated by the index — investors must be satisfied with market returns because that is the best any index fund can do.
Lack of control — managers cannot take action. Index fund managers are usually prohibited from using defensive measures, such as moving out of stocks, if they think stock prices are going to decline.

The debate between active and passive investment management will, no doubt, continue and from time to time one approach may be more popular than the other. As an individual investor you must ignore the trend of the moment. The most important aspect of your wealth management plan is that you actually have a plan—and that it helps you sleep at night.

Harp Sandhu, BA Econ., CSA
Investment Advisor
Phone 250-978-5362
Toll free 1-877-978-9300
www.macquarieprivatewealth.ca/sandhu

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