When exchange-traded funds made their debut in the early 1990s, they revolutionized the investment industry, not only by offering a different way to buy a fund, but also by introducing many people to the concept of passive investing. In its simplest form, passive investing means that a fund manager structures his or her portfolio so that it precisely replicates the performance of a market index, such as the S&P/TSX Composite or the Dow Jones, for example.
This contrasts with the active management that is still practiced today by most mutual funds, where managers try not only to match the performance of an index, but to beat it by selecting individual securities, market sectors or other investment themes that they believe will outperform the market.
Passively managed funds usually come with much lower costs than their active counterparts, because the fund company doesn't have to hire analysts and managers to study the market and pick what they believe to be winning investments. They just have to observe what the index does and replicate its moves. The most basic ETFs in Canada charge less than a tenth of a percent in management fees, compared with more than two percent for the average actively managed equity fund. They are also much easier to understand for the average investor, who may not grasp all the subtleties of an active manager's strategy. Most of the time they simply hold the largest stocks on a specified market, in proportions that reflect their market capitalization.
However, investors typically want to beat the market, not follow it, and they can't do that with passive funds. But while active managers offer the potential to outperform the market, studies have shown that very few of them are successful at it consistently.
In recent years, the lines between active and passive have been blurred somewhat by the introduction of a new breed of ETFs that we at Morningstar call strategic beta, which others also call smart beta. While technically speaking they follow an index and are therefore passively managed, their index is based on various factors, such as high dividends or low volatility, and rules that are determined by investment experts, which gives them an element of active management.
