By elmads

Funds are built in the good intention of giving an opportunity for the people to grow and multiply their hard-earned money, without the need to do extensive research and analysis about the asset classes and the markets.

People, not knowing anything about investing is the ultimate barrier to venturing into this world, despite the vast free information that they could consume.

Nonetheless, it is a widely known fact that not everyone is and will be interested in the field of finance and investing. That is why I am a proponent of mutual fund investing for those who do not have time or interest to learn more about it.

Click on the link “Mutual Funds” if you want to know more about its basic principles and how it works.

Funds are special kind of instrument because we entrust our hard-earned money into a fund manager to do the right investment decisions in our behalf. The question is, where do mutual funds actually base their investments? do they even track any benchmark to see if the investment returns of the fund is good or not? To answer these questions we first need to understand the Market Index.

What is a market index

An index is a group of stocks that represents a certain theme, mostly about the overall market or sector performance. See examples of the popular indices in the US, UK and Philippines.

• Standard and Poor’s 500 Main Index (also called S&P 500 index) in the US, which holds the top 500 large capitalized stocks in the US.

• Financial Times Stock Exchange 100 Main Index (also called FTSE 100 index) in the UK, which holds the top 100 large capitalized stocks in the UK.

• Philippine Stock Exchange Main Index (also called PSE index) in the Philippines, which holds the top 30 large capitalized stocks in the Philippines.

The next time you see and encounter a index, always look what it represents, it can be the general market of a specific asset like stock and bonds, or an industry like banking, retail, or oil.

The criteria used in order to choose which company stock will be able to enter a specific index differs, but the most popular method is through market capitalization (Company’s Stock Price X Total Shares Outstanding of the company). This means that companies with higher stock prices will have a higher chance to enter and influence the overall performance of the index. If you got confused with my explanation I highly suggest for you to read my blog titled “Stocks and Shares”, in which I discussed further each breakdown of shares and also its difference with the term stocks.

I’ll use a basket of orange as an analogy. In order for an orange to qualify in entering the basket of fruits we have, it needs to be a large orange fruit with a minimum weight of 180 grams. Furthermore, only 20 large orange fruits are allowed because that is the max capacity of our basket.

Mutual funds base their performance by comparing their fund returns to the market indices, as a benchmark. This is why we have been encountering the terms of “outperformed and underperformed”, which just means that the fund out or under performed a certain index it follows.

NOTE: I’ll make a legend to differentiate the Main Index to the Index Investment Funds

Green = Main Index

Blue = Investment Fund

Passive Funds

These are the funds that reflect the specific index it follows. This means that whatever the stocks the main index contain will also be the same stocks that the fund will have. For instance, the Vanguard FTSE 100 Index fund, which is owned and managed by an investment institution named Vanguard Group. This a passive fund that reflects the FTSE 100 index in the UK stock market. Below are the holdings of both the fund and the main index.

FTSE 100 Index as of 10^th of February 2021

Vanguard FTSE 100 Index fund as of 10^th of February 2021

With almost the same weight on the stocks held in the fund and index, it is then expected for the returns of the fund to also mirror the returns of the main index. Below is the 1 year return of the Vanguard FTSE 100 Index fund and the main FTSE 100 Index, from May 2020 to May 2021.

As depicted from the above chart, the returns of both the fund and the main index are very identical with some instances of discrepancies in returns, but only in a miniscule percentage.

The beauty of passive fund investing is that they have less fees due to reduced buying and selling frequency of stocks, that is because the main index it follows do not change the company stocks it holds that much. When a main index will add another company in its holdings, then it will surely remove another company because there is a max limit of companies it can only hold. Plus, the weighting of those companies will also shift depending on how large of a company will enter the index based on market cap.

These changes will also be copied by the passive index fund investment. That means that they will sell whatever the main index removes and buy the new company that will be entering the main index. This happens not so often, that is why there is less buying and selling, hence less transaction fees.

Active Funds

These are the funds that try to beat the index that it follows. In here, the active fund managers do the extensive research on the asset class where the fund invest in, for the purpose to outperform the market index. As an example, I’ll be using the FTSE UK All Share Index, which comprises of 641 publicly listed companies in the UK from the small capitalized stocks to the large capitalized stocks. While, the comparative active fund will be the Vanguard Active UK Equity Fund.

Below are the holdings of both the Index and the Fund.

FTSE UK All Share Index as of 10^th February 2021 – I bet you noticed it as well, the top 10 companies of the All Share Index are the same as the top 10 companies held by the FTSE 100 index, because both of them are heavily weighted on the company stock who has the largest market capitalization (Company Stock Price times Shares Outstanding of the company). The only difference is that FTSE UK All Share Index holds 641 companies in the index (from small, medium and large capitalization companies), whereas the FTSE 100 index only constitutes of the top 100 large capitalized companies.

Vanguard Active UK Equity Fund holdings as per 10^th February 2021

As clear as day, we could see the major significant difference of both the main index and active investment fund by just their top 10 holdings. This means that top 10 companies and all other companies held by Vanguard Active UK Equity fund should be able to outperform the FTSE All Share Index company weightings based on the active fund’s research and study.

Below is the 1 year head on comparison of the two, from November of 2019 to February of 2021.

As illustrated from the above chart, Vanguard Active UK Equity fund completely outperformed the FTSE All Share Index by almost 14% as per the February 2021 data. This is a major win for the Active fund managers.

That being said, the frequency of trading with Active funds are almost in a daily basis that is why it accumulates capital gains taxes and transaction fees regularly, which are usually shouldered by the investors who placed their hard-earned money on the fund. This is the reason why active funds have higher fees compared to their passive funds counterpart. With funds, it is true that with the promise of higher returns comes with higher fees.

Passive vs Active Funds

This has been an old debate about both funds. There are a lot of factors that every investors throw at one another just to defend their champions. Nevertheless, both funds have their unique qualities that the other does not have, which I will focus more in here.

Passive funds have ultra low fees due to the less transactions that the fund manager does. People always think of what asset will give them the highest return but do not even consider the fees that they are paying for, which could pull down the potential total returns that they could get. This is the same with taxes, there are non-taxable accounts in investing that everyone should be utilizing depending on their financial and investment goals. This is because taxes are holes in our investment buckets, money leaks out in our investment portfolio (dividend tax and capital gains tax).

Active funds have wonderful flexibility and freedom. What I mean here is that these funds have the freedom to purchase whatever stocks they want as long as it is still within the scope of the fund’s goals and objectives. For example, if the S&P 500 index have a weighted holding in Apple Inc. of 6% total, then the active fund could either increase their Apple holdings to more than 6% or decrease it to less than 6%, if they deem it essential. This is all dependent on the funds research and strategy, for the sole purpose to outperform the market. Moreover, funds could also employ hedging strategies like put options and shorting sales, which are complex investing methods already.

To sum it up

As you have read, it is a waste of time to point fingers which one is the better type of fund, either active or passive. What matters here is, which one will be suitable for our investment objectives.

The essence of investing is to multiply and grow our hard-earned money for a certain long-term goal in our life. It is true that we will not need money when we die, but we need it in order to use it as a tool to build and create what we truly want and love in our lives.

We must be realistic and be aware to the fact that having an average 7%-9% returns using passive funds could be fine, do your own computation and maybe you will be able to achieve your financial goals with the amount you invest per month with that kind of return. Or, with the computations that you did, it could be that the robust gains of active funds will be able to offset the fees that they ask their investors to pay, this in turn could end into a larger returns for you in the long run.

Remember that, our investment decisions will always boil down to our needs, our own time, effort, personal circumstances and most of all the, one that gives us a goodnight’s sleep and peace of mind.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.