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Active Funds vs. Passive Funds: Which Should You Buy During Volatility?

SmartAsset: Active Funds Struggle to Beat Passive Funds. Which Should You Buy During Volatility?
SmartAsset: Active Funds Struggle to Beat Passive Funds. Which Should You Buy During Volatility?

Active fund managers make their reputation on helping investors navigate skillfully through volatile markets. But only 40% out of almost 3,000 active funds survived and outperformed average passive funds between June 2021 and June 2022. Here’s what Morningstar’s semiannual report says and whether you should invest in active or passive funds during market volatility.

A financial advisor can walk you through the advantages and disadvantages of investing in active and passive funds.

Active Managers Failed to Capitalize on Volatility

While results varied widely across asset classes and categories, the Chicago-based financial firm Morningstar reported that 60% of active funds did not survive or outperform average passive funds over 12 months ending in June 2022.

The midyear report of the Morningstar Active/Passive Barometer measures how U.S. active funds performed against passive funds in respective categories.

As a whole, Morningstar says that most active fund managers failed to capitalize on volatility, dropping from a 47% success rate against average passive funds in midyear 2021 to 40% in midyear 2022.

However, the report also shows that U.S. active managers in midyear 2022 hand-picked better stocks (45%) than in midyear 2021 (43%). But the success rate for foreign stock fund managers, by comparison, fell from 37% in midyear 2021 to only 23% in midyear 2022.

Active bond managers, on the other hand, had an even tougher year: Just 29% beat out their average passive fund peers.

The report shows that bond managers did better with high-yield bonds (32%) than corporate bonds (22%). But investors should note that success rates dropped by 47.4% for corporate bonds since midyear 2021 and fell by 41.4% for high-yield bonds over the same period.

One key finding for investors: Fees matter. When looking at a 10-year period ending in June 2022, Morningstar says the cheapest funds beat out the priciest ones with a success rate of 32% to 19%. Which means that you could actually “get what you don’t pay for.”

What Investors Should Know About Active Funds

SmartAsset: Active Funds Struggle to Beat Passive Funds. Which Should You Buy During Volatility?
SmartAsset: Active Funds Struggle to Beat Passive Funds. Which Should You Buy During Volatility?

Conventional finance wisdom says that active fund managers can help investors maneuver through volatility.

These managers rely on market analysis and research, financial forecasting and expertise to get the highest returns possible for a fund. They can also use hedging strategies to manage risk effectively.

But while their objective is to beat markets like the S&P 500 or the Nasdaq 100, this strategy does not guarantee stronger-than-benchmark returns.

In fact, like the Morningstar semiannual report shows, most actively managed funds can underperform their benchmark as passive funds hit target return goals.

Like with other financial investments, active funds have downsides that investors should consider.

First, you should know that your returns will be reduced by operating costs. Working with a professional manager typically means that investors pay a percentage for assets under management.

Second, you will have to pay for the cost of buying or selling investments in the fund. Managers tend to trade more often than passive funds, buying portfolios that include all the stocks and proportions of an index and selling a stock when it gets dropped from it.

What Investors Should Know About Passive Funds

Unlike active funds, passive funds focus on replicating the performance of a market instead of beating it.

This strategy holds long-term investments with the goal of capitalizing on steady market increases over many years.

In this sense, passive management is directly opposed to active management, which calls for frequent trades to get above-market returns. And because passive funds aren’t sold or bought as often, investors lose less money on transaction costs.

Passive funds can also be more tax-efficient when compared with active funds. Another consequence of frequent trading is that you will have to pay more taxes. Each time an asset is sold, investors must pay a capital gains tax. (Note that if you sell an asset held for less than a year you will have to pay ordinary income tax on it. For assets held over a year, you will pay a maximum capital gains tax rate of 20% in 2022.)

One downside to consider before making a passive investment: When you invest in a passive fund, you lock yourself into the index fund or investment that you make. So when stock prices change, you can’t actively alter your investments. This means you won’t have the ability to capitalize on market surges or protect funds from downward slides.

Overall, passive funds have lower operation costs than active funds because they do not have to pay for a professional manager and trades are minimized. You should keep in mind, however, that fees vary from fund to fund. So this will impact your returns.

Bottom Line: Which Should You Invest In?

SmartAsset: Active Funds Struggle to Beat Passive Funds. Which Should You Buy During Volatility?
SmartAsset: Active Funds Struggle to Beat Passive Funds. Which Should You Buy During Volatility?

When considering both active and passive investments, investors must factor in their risk tolerance, time horizon and investment goals. Long-term investors, for instance, may prefer to hold passive funds over many years to capitalize on steady market increases. But for those who are more focused on performance, active funds could offer other investment opportunities.

During volatility, active fund managers can use hedging strategies to manage risk and buy or sell assets when the market fluctuates. But as the Morningstar report shows, active funds do not guarantee stronger-than-benchmark returns. And passive funds could in fact deliver what you are not paying for.

One thing is certain: Both investments carry risk. So make sure to weigh the pros and cons specifically for your financial circumstances before investing. And consider matching with a financial advisor to strategize what works best for you.

Investment Planning for Volatility

  • If you’re unsure which asset allocation mix will help you meet your investment goals, a financial advisor can help you compare different options for your financial plan. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • SmartAsset’s free investment calculator can help you estimate how much your money could grow over time.

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