Passive Management Explained
Written by Preet Banerjee

Friday, March 13th, 2020

Passively managed funds are gaining ground in Canada at a very fast pace, closing the gap in market share when compared to actively managed funds.

What are passively managed funds?

Passive vs. Active Investment Management

Passive investment management generally refers to an investment strategy that seeks to copy the holdings and performance of an investment benchmark. So what's an investment benchmark?

What's a Benchmark?

As an example of what a benchmark is, the S&P/ TSX Composite Index is the main benchmark for the Canadian stock market. When people say "the TSX was up 2% today," they're referring to the S&P/TSX Composite Index. This index consists of over 200 publicly traded Canadian stocks. There are many more Canadian stocks than that, but this particular group of stocks represents the bulk of money invested in public Canadian stocks. So it's widely considered as a main indicator for the performance of the Canadian stock market as a whole.

Passively Managed Investment Funds

A passively managed investment fund would hold all the member holdings of the benchmark in the same proportions. So if a certain stock represented 5% of the benchmark, then a passively managed investment fund based on that benchmark would have 5% of its holdings in that stock as well.

Active Investment Management

On the other hand, active investment management is the process of making investment decisions in an attempt to outperform the risk-adjusted return of a given benchmark. This requires holding investments that deviate from the holdings of the benchmark. If the fund manager thinks a certain stock is going to do really well, they might hold more of that stock. And if they think a certain stock is going to do poorly, they might not own it at all. They may also buy and sell individual stocks on a regular basis, all in their attempt to outperform the benchmark.

Passive Doesn't Necessarily Mean Low Risk

One common misconception about the term "passive investment management" is that it means "low risk." This might be because "passive" is considered the opposite of "aggressive," and we hear the term aggressive in the world of investing when talking about higher-risk portfolios. It's important to note that in the case of passive investment management, "passive" means something else. It refers to the style of investment management that doesn't actively try to outperform a benchmark, and instead tracks the benchmark, whether it's going up or down.

Less Work, Less Cost

Because passively managed funds (which are also called index funds, or index-based funds) don't require hiring a team of investment professionals to research individual holdings and determine whether or not to buy or sell those holdings on an ongoing basis, the cost of running them is normally much lower than an actively managed fund.

Because fund costs lower the fund returns (for all types of funds), this helps explain why passively managed funds tend to outperform actively managed funds in the same category over longer periods of time. Costs make a big difference to investor returns.

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