Active and passive funds: the power of both

Active and passive funds can help create a portfolio that reflects your investing style.

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Key takeaways

  • Actively managed funds provide the potential to outperform market benchmarks.
  • Some passively managed investment options can provide low-cost exposure to market segments.
  • Many investors combine these 2 strategies in their portfolios.

In recent years, the debate on active vs. passive investing has intensified, with passionate supporters on both sides. Fidelity was built around actively managed funds and continues to believe that rigorous research, sophisticated portfolio construction, and expert trading allow actively managed mutual funds to add value for investors. Fidelity is also one of the industry's leading providers of passive investment products, which seek to track the performance of an index. Many investors find a role for both actively managed mutual funds and passively managed index funds or exchange-traded funds (ETFs).

Active strategies use the intentional selection of securities to try to outperform a benchmark index, while passive approaches try to simply match the returns of a benchmark index, often at lower cost. Owning a combination of both strategies could offer a form of diversification for some investors by offering the potential to outperform (from active) alongside relatively consistent lower-cost market exposure (passive). One approach to combining active and passive is to use each strategy for exposure when you think it has the best chance of outperforming.

Passive approaches: matching the market with low costs

Passive investing, also known as index investing, is rooted in the efficient market hypothesis (EMH). There are different degrees of EMH, but the cornerstone of the theory is that stock prices generally reflect all publicly available information at any given time. Therefore, EMH concludes that it is very difficult to consistently beat the market. Instead of trying, index funds and ETFs provide a low-cost way to invest in a particular market, attempting to match it before fees.

Index funds and ETFs for familiar markets are usually easy to understand. Because they simply attempt to replicate a benchmark, passive strategies tend to have lower fees than actively managed funds. However, not all index funds/ETFs are the same. They may use different benchmarks, may use diverse techniques for matching their markets, and may have different management fees. Indeed, because most passive index funds and ETFs are simply looking to match the performance of an index, differences in fees can be a key factor separating the performance of similar index investments.

Active strategies: selecting securities to beat the market

Advocates of active management believe that markets are not always perfect at determining the right price for securities (stocks or bonds). Periodic financial bubbles and market corrections seem to suggest that market inefficiencies exist. Indeed, if you've ever bought an individual stock, you likely believe that the market isn't perfectly efficient and market-beating bargains can be found.

Active portfolio managers attempt to identify market inefficiencies to deliver attractive returns for investors. They can hold investments in different proportions than the index, "overweighting" investments they think will do better than the rest and "underweighting" those they think have less appealing prospects. They can also choose to hold investments that are not in the benchmark index itself or avoid owning securities in the benchmark altogether.

Many companies that offer actively managed funds believe that in-depth analysis of a company, its products, industry, competitors, and other factors, can identify mispriced investments. Many also believe that markets tend to over- or underreact to short-term information, so portfolio managers with a longer time horizon can take advantage of temporary price fluctuations. In other words, they can attempt to "buy low, sell high."

Which approach might outperform, and when?

Market conditions could set the stage for either active or passive index funds to lead, at least in the short term. For example, in broad U.S. stock market rallies—markets where more stocks outperform the capitalization-weighted benchmark index—actively managed U.S. stock funds may have more success than in narrow markets, where a smaller number of stocks outperform and drive the bulk of returns for the index. This is because broader markets may provide more opportunity for active funds to generate better performance through the selection of outperforming stocks (within a broadly diversified portfolio).

Market breadth is not the only condition that may influence the success of active management, but it is a convenient metric because it can be measured in several ways. One relatively simple way uses widely available information. You can compare a familiar market capitalization–weighted index (where companies with more market cap take up more of the index) with an "equal-weighted index" (where every company starts off in the index with an equal proportion). When the equal-weighted index beats its market-cap peer, it generally signals greater market breadth (more companies in the index are beating the average). During periods when the market cap–weighted index outperforms, overall market performance is being driven by the larger companies within the index, and the market is considered narrower.

The chart below shows the performance difference between the market cap–weighted S&P 500® Index and the equal-weighted version of the S&P 500 for the past 24 years. The S&P 500 is an index of the 500 largest U.S. companies by market cap. During this 24-year period, there were 11 calendar years that can be classified as broad markets (green columns), 7 calendar years that can be classified as narrow (red columns), and 6 years with no strongly dominant trend. Although there are exceptions, actively managed U.S. large-cap equity funds have tended to perform better during extended periods of broad markets, and worse during extended narrow markets.

Importantly, there is no magic crystal ball that can predict whether the U.S. large-cap stock market will be broad or narrow in the future, whether active or passive will actually outperform in that market, or if any individual fund will perform in line with these averages. The lack of a clear trend in the recent past may help us understand why active U.S. large-cap funds have underperformed on average, but those conditions could easily change.

Finding longer-term investments to fit your portfolio

Many investors prefer to invest for the long term, and avoid trying to time the market. For them, selecting active funds means having confidence that those funds will outperform or match the market over time.

Although no fund or ETF can guarantee outperformance, actively managed funds have historically done better in some market categories than others. For example, in the popular stock market categories of international large-cap and U.S. small-cap, the average active fund has outperformed its benchmark over a time period stretching for more than 2 decades (from 1992 to 2016).1 In active bond funds, some categories of funds have tended to outperform indexes more than others, including investment-grade intermediate and short-term funds, municipal debt funds, and government bond funds.2

Moreover, key differences between the bond market and the equity market, such as how indexes are constructed and how securities are priced for trading, may favor well-resourced active bond funds and ETFs in other categories.

One category that has not fared as well is U.S. large-cap stocks, represented by benchmark indexes such as the S&P 500 or Russell 1000® (or "growth" and "value" versions of those indexes). While the chart above showed how active and passive funds have each had periods of market leadership overall, the average active U.S. large-cap fund has lagged the average passive fund over the long term (from 1992 to 2016), perhaps due to the greater efficiency of the market. But it's worth noting that in that category, lower-cost active funds from larger fund companies (presumably those with more resources for research and trading) have done better than average, and have outperformed their benchmarks during the full time period.3

Remember that these are long-term averages, using hundreds of funds over more than 2 decades. In any given year, the average active or passive index fund might lead. What's more, you can't invest in this average—individual active funds might do better or worse than their peer average in any given short-term period. That is why many investors will look at a fund portfolio manager's long-term track record and strategy for selecting investments to decide which funds to buy. (But always remember that past performance is no guarantee of future results.)

In addition, many studies have suggested that on average, funds with lower fees than their category peers have been able to return more to investors.4 For passive approaches, fees are typically an important driver for relative performance (the difference between benchmark index performance and the passive fund or ETF's after-fee performance), so it makes particular sense for passive investors to consider the expense ratio when researching an index fund or ETF. Because active funds seek to outperform the index—often using research and trading resources in the process—they tend to have higher expense ratios than index funds. So make sure you compare active fund fees with those of other active funds.

Investors can typically get information about how a fund or ETF's fees compare to those of peers. For example, this information can be found within the mutual fund library pages on Fidelity.com. (Learn more about the fund library in the Learning Center.)

The "Mutual fund expense ratio" table gives a snapshot of median mutual fund industry expense ratios as of the end of 2016. If a particular fund has much higher fees than other available options in the same market category and approach (active or passive), investors should try to understand why. The chart shows the median expense ratios for 3 different stock categories, sorted by active and passive.

Combining active and passive in your portfolio

Although both active and passive management have steadfast advocates, there's no rule that says these investment approaches are mutually exclusive. In fact, active and passive funds have the potential to complement one another in a portfolio. You could hold active funds in market categories you feel are less efficient or broader, with more opportunities for active management to add value through research and security selection. Or you could hold particular active funds in any market category, whenever you feel confident that those funds can outperform the benchmark index over your time horizon.

You could even hold a mix of passive and active funds within one category or style, as a way of trying to balance your expectations. If you are comfortable taking the risk of underperforming a benchmark in exchange for the potential to outperform, you may want to consider a larger allocation to active fund management strategies. If you have lower emotional or financial risk tolerance for underperforming the market, or simply would be satisfied with market-like returns, then you may want to consider a larger allocation to passive index funds and ETF strategies.

Whichever investing approach you favor, be prepared to endure the volatility that could come with your market exposures. If you are a long-term investor, you should expect to hold your portfolio through market ups and downs if you want to reap the diversification and return potential of your selected funds and ETFs. Remember that the most important investment decision you make may be deciding on a mix of stocks, bonds, and cash that is appropriate for your goals, investment timeline, and risk tolerance, not the particular funds you choose.

But the key insight for many investors is that you don’t need to choose between index approaches and active strategies—it doesn't have to be all or nothing. By mixing actively managed funds with passive index approaches, you can try to get the best of both worlds.

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