Active and Passive Investing

Active and Passive Investing

Every day you can easily find out about how the stock index performed.  The news, newspapers, and various online resources all report on it, letting you know whether the TSX is up or down 100 points that day, for example. But what does that really mean and how much does it relate to your investments?

Companies that gather and publish data about stock markets create indices to help investors understand how the overall market, or segments of it, are performing. There are over 1,500 stocks that trade on the Toronto Stock Exchange. The TSX index reflects the performance of only 221 of them.  The publisher of the TSX Composite Index has criteria for choosing and weighing those company’s shares based on the size of the company and the number of shares traded.  So, shares of RBC, one of the largest companies in Canada will have a heavier weight in the calculation of the index than will Linamar, a car parts company whose total value is much smaller and is traded less compared to RBC.

On any given day, some of the shares traded on the exchange and represented in the index will go up and some will go down. And the degree to which they are up or down will vary from company to company. The index is meant to reflect the overall market to give you a sense of how, generally speaking, stocks are doing.

Depending on how you invest, this can help you evaluate the effectiveness of your strategy.  If you use a mutual fund to invest in Canadian stocks, you will look at the performance of that fund and compare it to the overall market. If the index was down significantly over the past year, you wouldn’t find it unreasonable if the fund that you own was down too.  The portfolio managers of the fund will typically hold 30 to 50 stocks. They believe that they can choose some stocks and not others and give you, the investor, some sort of advantage.  One way to measure the success of their approach is to compare it to the index. As investors, we do this, and we refer to the index as the “benchmark.

Cartoon drawing of a financial advisor talking to his client

Now, there are funds that simply replicate what is held in the index. The fund will hold exactly the same stocks in the exact same proportion as the index and the performance will be very similar to that of the index.  These funds are called “passive” investments.

The fees charged by active managers are higher because of the people, skill, and resources required to carry out the process.  That makes it more difficult for them to outperform because they have to add enough value through their stock selections to beat the benchmark and cover their fees.  An index fund will always slightly underperform the index because it will get the return of the index minus the fee, albeit a very small one.

There is a lot of debate these days about active vs passive investing and whether it is worth it to pay fees.  I believe that there are pros and cons to each approach.  Active investing can add value to certain parts of a portfolio. I am open to all options and choose the best one for the situation.

Contact me to discuss portfolio construction and how I balance active and passive investing to manage costs and improve returns.

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