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Active Investing ETFs and Mutual Funds

A Checklist for Choosing Between Active and Passive Funds

One of the challenges for investors in ETFs and mutual funds is deciding whether to use an actively managed (“active”) or a passively managed (index) fund.

by Charles Rotblut | March 2023

Charles Rotblut leads a class in AAII's new Essential Investing Video Course. Go to https://www.aaii.com/ves for more information and to subscribe.

One of the challenges for mutual fund and exchange-traded fund (ETF) investors is deciding whether to use an actively managed (“active”) or a passively managed (index) fund. We’ve created a checklist to help you think through various considerations and reach a conclusion.

Actively managed funds rely on fund managers to handpick securities. Active managers may have the discretion to time the market and hold cash investments. They offer the potential, but not the guarantee, of beating the benchmark index or taking advantage of areas within the financial market less covered by indexes. Passively managed funds seek to mimic the returns of an underlying index. They tend to have very low expense ratios and are designed to limit the odds of underperforming the index.

When we first published the checklist in Investor Update on February 2, 2023, several AAII members commented on the performance of active funds. We’ve incorporated responses to these concerns in this article.

As you look at the checklist, you will notice three columns with spaces to mark your preferences: The first two pertain to whether your fund preferences for a specific criterion lean more toward active or passive management, and the third column is reserved for whether those criteria are key considerations for you. Anything marked in this column should significantly influence your decision. (Download a PDF of the checklist here.)

The checklist is broken into four main characteristics: restrictions, returns, cost and types of investments. While there are certainly other criteria to consider when choosing between specific funds, we believe these four characteristics provide a good framework for choosing between active and passive management.

Restrictions

The simplest question is the first one to answer: Are there any restrictions on what you can invest in?

If you want to buy a fund within a 401(k), 529 college savings plan or health savings account (HSA), you may have no choice but to buy, say, an actively managed mutual fund due to the plan’s offerings. In such instances, the decision is made for you.

Returns

Do you want to attempt to beat the market or get the market’s return? This question prompted the most feedback from AAII members.

There is reason to be skeptical of fund managers’ ability to outperform. Data from S&P Global’s SPIVA report shows that just 18% of equity and 30% of fixed-income funds maintained their five-year top-quartile performance rankings over the following five-year periods (“U.S. Persistence Scorecard Mid-Year 2022,” November 28, 2022). While there are some active managers who outperform, identifying them in advance is very difficult.

Passively managed funds, on the other hand, are designed to mimic the performance of their underlying benchmark indexes less their expense ratio.

  • Beat the market/benchmark index—put a checkmark under Active
  • Get the market’s/benchmark’s return—put a checkmark under Passive

Do you think you can select managers who will outperform in the future? As the aforementioned data from S&P Global demonstrates, this is not easy to do.

  • Yes—Active
  • No/Not sure—Passive

Are you willing to endure periods of underperformance for a chance at long-term outperformance? Even good fund managers can underperform their peers for periods of a year or longer with their outperformance not truly being evident for periods of five or 10 years.

  • Yes—Active
  • No—Passive

Are you comfortable owning a fund that is more volatile than its category peers? Actively managed funds can be more volatile than their category peers because outperformance comes from investing differently than their benchmarks and category peers. (The category risk index, which can be seen on a fund’s Evaluator page on AAII.com, shows whether a mutual fund’s or an ETF’s returns have been more or less volatile than its peers.) Your ability to tolerate larger swings in an actively managed fund’s returns will determine your ability to stick with it.

  • Yes—Active
  • No/Not sure—Passive

Will you periodically check the fund to ensure it still maintains favorable risk/return potential and hasn’t changed its approach? Actively managed funds can more easily change their approach, especially when a new manager takes over.

  • Yes—Active
  • No/Not sure—Passive

Cost

Cost is the one aspect of fund returns an investor can control. There are two key aspects listed on the checklist that are revealed in the expense ratio and the tax-cost ratio. We do not think investors should pay any loads or transaction fees when it comes to mutual funds if comparable no-load alternatives or ETFs are available.

Is cost important? In other words, how important are low expense ratios to you? The higher the expense ratio, the greater the gross return a fund must realize just to match the category average net return. You may be willing to consider a fund with a higher expense ratio if you believe an active manager can outperform or if they target investments that are less widely followed.

  • Very important—Passive
  • Not the most important criteria—Active

Does tax efficiency matter? The tax-cost ratio—also accessible on the AAII Mutual Fund and ETF Evaluator pages—measures how much of a fund’s annualized return is reduced by the taxes paid on distributions, assuming the maximum marginal tax rate. The lower the ratio, the more tax-efficient the fund. This is a consideration if you intend to hold a mutual fund or ETF in a taxable account. It is not a consideration if you are using a tax-preferred account such as a 401(k), IRA, Roth IRA, HSA or 529.

  • Yes—Passive
  • No—Either active or passive

Types of Investments

Are you investing in widely followed asset class categories or asset categories that are less followed? The most popular asset class categories are likely to be represented by passive funds. More specialized areas aren’t as widely tracked and therefore offer better opportunities for active management to outperform.

  • Widely followed—Passive
  • Less popular—Active

Download a PDF of the Active vs. Passive Fund Decision Checklist here.

Active vs. Passive Fund Decision Checklist

Discussion

ROBERT A from NC posted over 3 years ago:

Wow. My decision-making is a lot simpler. Actively managed funds generally underperform the market, AND their fees are higher than those of index funds. To pick the "right" actively managed fund, you have to be able to get inside the head of the manager(s), and you have to hope they stay in charge of the fund while you're holding it. On top of that, you have to hope they don't have a mental breakdown or otherwise go off the deep end. (Remember, they're human, and they're under a lot of pressure, especially when the market is having hiccups.) Too much for me. For fund investing, I'll stick with low-expense-ratio equity index ETFs. At least I know somebody else's bad judgment isn't going to tank my fund while hitting me with high fees.


JOHN L from NJ posted over 3 years ago:

I agree with Robert A! Active managed funds according to SPIVA fall short of their index over 20 year periods 94% of the time. There is no known way to select the 6% of active funds that will outperform during the next 20 years. The odds are deeply against success when selecting active funds. It is almost investment malpractice to create the decision check list in this article rather than advise investors to use passive index funds.


Deepak M from FL posted over 3 years ago:

I am also in the camp of "passive" investing however, here is how I think about it... Passive investing means picking an allocation strategy and sticking with it. Keep buying index based ETFs, that are also low cost, and keep buying in your accumulation years and rebalance annually. One can pick a "somewhat" actively managed fund such as AVUS which I substitute for VTI. In my mind, both are "passive" ETFs however, AVUS has some broadranging methodology to apply to their ETF. I actually own both as I started out with VTI but since Paul Merriman published their update to the "Buy and Hold" 10 Fund portfolio, i switched to buying AVUS.


Norm Y from OR posted over 2 years ago:

I agree with the 3 comments above. My investments lean toward income, high dividend yield and, hopefully, growth. Depending on the circumstances, I don't mind an expense ratio in the 2.0% range, but I like to try to keep them below that. I've seen some say that higher ranges really don't affect your return that much, but those 5 to 8%, or more expense ratios, kind of scare me. I'm sure you've probably addressed this situation already, if so could you direct me to it on the website. Otherwise, would it be possible to explain the different result from two equally priced funds with equal growth for a year. One has a yield of 5% in dividends with an exp. ratio of 0.75%. The other has a yield of 8.5% with an exp. ratio of 5.25%. Actually, I'd be happy with any range of dividend and expenses that you would care to use. Or, is there more to it than just yield and expense. Thank you for any clarification that you can give me.


BARRY J from TX posted over 2 years ago:

This checklist is just as advertised – simple. It uses only 2 comparison statistics – yield and ER. It completely ignores the ADDED COST of “the magic” in active and passive fund management – i.e., the OPERATIONAL COSTS that are deducted from GROSS yield to get to REPORTED yield. This is where the “nothing up my sleeve” (meaning “please pay no attention to what I am doing with the other hand in my/your? pocket) shenanigans that reduce the NET yield reported. These are the costs from: #1 sub-optimization yields from selecting a “favorable” benchmark to “replicate”/”track” from among over 1,000 choices;. #2 fees for the services of active participants who sell/buy fund holdings in bulk transactions to adjust fund imbalances due to market fluctuations; #3 costs of fund manager over- and under-performance versus the benchmark (measured by R-Squared and Over/Under Capture Ratios); and #4 “transaction fees,” the cost of buying/selling a low cost ETF in a brokerage account that charges $75 or so (an added 0.075% per $10,000) fee; and over/under performance due to fund management decisions: #5 standard deviation (fund volatility over time); #6 Sharpe ratio (reward per unit of risk); #7 beta (volatility versus benchmark); #8 alpha (excess return versus benchmark). Just as many AAII equity screens focus on operational costs as key indicators of “quality” returns produced, these “hidden” fund expenses reduce net yield. As Forrest Gump’s mother said, “Simple is as simple does.”This checklist is just as advertised – simple. It uses only 2 comparison statistics – yield and ER. It completely ignores the ADDED COST of “the magic” in active and passive fund management – i.e., the OPERATIONAL COSTS that are deducted from GROSS yield to get to REPORTED yield. This is where the “nothing up my sleeve” (meaning “please pay no attention to what I am doing with the other hand in my/your? pocket) shenanigans that reduce the NET yield reported. These are the costs from: #1 sub-optimization yields from selecting a “favorable” benchmark to “replicate”/”track” from among over 1,000 choices;. #2 fees for the services of active participants who sell/buy fund holdings in bulk transactions to adjust fund imbalances due to market fluctuations; #3 costs of fund manager over- and under-performance versus the benchmark (measured by R-Squared and Over/Under Capture Ratios); and #4 “transaction fees,” the cost of buying/selling a low cost ETF in a brokerage account that charges $75 or so (an added 0.075% per $10,000) fee; and over/under performance due to fund management decisions: #5 standard deviation (fund volatility over time); #6 Sharpe ratio (reward per unit of risk); #7 beta (volatility versus benchmark); #8 alpha (excess return versus benchmark). Just as many AAII equity screens focus on operational costs as key indicators of “quality” returns produced, these “hidden” fund expenses reduce net yield. As Forrest Gump’s mother said, “Simple is as simple does.”


JAMES B from TX posted over 2 years ago:

A look at the performance of the Legg Mason Value Trust under Bill Miller should convince you that indexing is the way to go. For 15 years he beat the S&P 500 and the fund grew to enormous size. Then came the last three years and if the investors who were in the fund had been in index funds they would have been better off. He (Miller) even admitted that it wasn't skill that played a role in the 15 years he beat the index but luck. I'm mostly in index funds but there are two actively managed funds that I think bear looking at - Vanguard Wellesley Income fund and Vanguard Wellington fund and I hold about 10% of my total portfolio in them. Have not been disappointed in them. I did a spreadsheet on Wellington starting in 1929, the year the fund started, for every dollar invested, if you took out an initial 4% and adjusted it for inflation, both up and down, for the years following you never ran out of money. A good read on Wall Street is 'Where are The Customers Yachts?' by Fred Schwed, Jr. It will give good insight into the world of active management and why to avoid it.


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