How do I Know if a Fund is “Passive”?

In response to my active vs. passive investment fund performance post, a reader, Heidi, wrote in with a question,

How do I know if my vanguard funds are “passive”?

That’s actually a great question, and an important basic that I’ve never covered here at 20somethingfinance. And it provides an excellent back-to-the-basics teaching moment. Thanks for asking, Heidi!

To answer that, let’s take a step back and first cover what “active” and “passive” fund management is in the first place.

What is Active Fund Management?

Actively managed funds are mutual funds that have an investment manager or multiple managers actively making subjective buying and selling decisions on what equities (e.g. stocks and bonds) they would like to invest their funds assets in. In other words, they own what they want, when they want it, with the hope of selecting investments that will give their fund the best return on investment. They also sell what they want, when they want to.

For this service, they charge management fees (expense ratios) that are usually significantly higher than their passive fund counterparts, because that is how they compensate the fund management team.

What is Passive Fund Management?

Passive management refers to either index funds or ETFs (exchange traded funds) that are not actively managed by a fund manager who is making subjective buying and selling decisions on what stocks/bonds they would like to include in the fund they are managing.

Instead, passive funds aim to simply mirror the performance of the market benchmark index they are following as closely as possible. Some examples of market indexes are,

• S&P 500 (top 500 U.S. corporations in market value)
• Russell 3000 (top 3,000 U.S. publicly held corporations in market cap value)
• Russell 2000 (excludes top 1,000 of the Russell 3,000)
• MSCI US REIT Index (a gauge of real estate stocks)
• MSCI EAFE Index (large and mid-cap securities across 21 developed markets, excluding the U.S. and Canada)
• FTSE Emerging Markets (large and mid cap securities from advanced and secondary emerging markets)

Investing in index funds and ETFs is often referred to as “passive index investing“. Some people say it’s boring, but I think passive index investing is spectacular.

The Benefits of Passive Versus Active Management

There are numerous benefits for passively managed funds over actively managed funds:

1. Cost: this is a hugely important benefit. Because passive funds do not need to employ a staff to actively manage, their annual expense ratios are generally very low, sometimes more than 1% or more lower than actively managed funds. That may not sound like a lot, but it is. It could compound to hundreds of thousands of dollars over an investor’s lifetime.
2. Tax efficiency: index funds generally don’t trade as much as actively managed funds might, so they’re typically generating less taxable income.
3. Diversification: indexes can hold hundreds or thousands of securities within a single fund whereas actively managed funds typically hold much less, and therefore, aren’t as diverse.

How do I know if an Investment is Passively or Actively Managed?

Back to Heidi’s original question.

A passively managed fund is simply either an index fund or an ETF. And in a fund’s summary overview, it will tell you whether it is an index fund, ETF. If it doesn’t, you can probably assume that it is actively managed. For example, Vanguard’s REIT ETF (VNQ) states that it is an ETF and,

Goal is to closely track the return of the MSCI US Investable Market Real Estate 25/50 Index.

This fund is following the return of an index. Therefore, it’s passively managed. If it’s not that explicitly laid out, take a look at the fund’s prospectus to confirm.

When choosing between ETFs versus index funds, there are some minor differences. The most notable is that ETFs trade on the stock exchange throughout the trading day, while index fund transactions occur at the end of the trading day, like all mutual funds. Many online brokers offer commission-free ETF trading for a selection of ETFs and expense ratios are very similar, if not the same, between index funds and ETFs offered by the same provider. Some index funds may have high opening minimum deposits, which can make their ETF counterparts more obtainable.

If you want to check whether your funds are actively or passively managed, just search through the company’s list of ETFs or index funds to see which are on the list. I prefer Vanguard because they have the lowest management expense ratios (and if you’re going with a passively managed fund that tracks an index, why not go with lowest cost?). Here are a few places to start:

• Vanguard ETFs
• Vanguard index funds
• iShares ETFs
• Fidelity ETFs
• Fidelity index funds
• State Street Global ETFs
• Schwab index funds
• Schwab ETFs

Unfortunately, nearly half of invested assets are still in actively managed funds (at the expense of investor performance), but now you have the knowledge to help change that!

Related Posts:

• Millennials are Embracing Passive Index Investing & Vanguard
• Vanguard Lowers Fees (Again)
• Vanguard has 3 S&P 500 Index Funds. How do you Choose?