Active vs. passive investing in Canada: Which strategy wins?

Active investing is exactly what it sounds like: an investor (or more likely a fund manager) takes an active role in making investment decisions such as which stocks to buy, which ones to avoid, and when to buy and sell.

The goal of an active fund manager is to beat a benchmark index, often referred to as “the market.”

For example, an active mutual fund manager investing in Canadian stocks would likely aim to beat the TSX/S&P Composite Index, the benchmark Canadian index representing about 250 of the largest companies in Canada.

Similarly, an individual investor who invests primarily in Canadian stocks should also compare his or her results against a benchmark like the TSX/S&P Composite Index to see if their “active” investing strategies are adding value and beating the market.

The case for active investing goes something like this: smart fund managers can analyze stock prices and market conditions better than average investors and therefore can make better, more informed decisions on which stocks to buy, sell, or hold (and when).

The promise of active investing is that a smart fund manager can take advantage of upswings in the market but also be protected from downswings by rotating away from stocks that fall out of favour. Active investing can be boiled down to stock picking and market timing.

Passive investing is also exactly what it sounds like: instead of actively picking stocks and timing the market, investors passively hold the entire market using an exchange-traded fund (ETF) or an index mutual fund.

The goal of a passive investor is not to beat the market but to closely mirror its returns, minus a small fee.

For example, a passive index fund tracking the TSX/S&P Composite Index would simply hold all 250 Canadian stocks in that index using the exact weight and proportions used to construct the index (e.g., the largest stocks make up a larger percentage of the holdings).

An individual investor following a passive strategy would build a portfolio of index funds or ETFs that track broad market indexes like the TSX/S&P Composite Index, the S&P 500, and the MSCI World Index.

The case for passive investing is that it’s nearly impossible for investors to identify which stocks will outperform over long periods of time, so it’s best to hold every stock and simply capture the returns of the entire market.

Just as importantly, passive funds cost less than their active counterparts because they don’t need to pay a fund manager to make investment decisions.

Fintech has made passive investing easy. With a robo advisor, a robot builds you a diversified portfolio of low-fee ETFs and index funds for a small (typically around 0.5%) fee. Or if you’re a savvy investor, you can even build your own portfolio using an online brokerage. It’s that simple to get started investing.

The telltale sign that a fund is active is that it costs more. Active fund fees range from 1% MER on the low end to 2.5% MER or more on the high end. Active funds will likely state that their goal is to outperform a benchmark index, not to passively track its returns. Finally, an active fund’s holdings will likely be more concentrated than that of its benchmark index.

ETF investing is ideal for passive investors, as they tend to charge a fraction of the cost of index mutual funds. However, not all ETFs are passively managed. There are now more than 850 ETFs available in Canada and they range from traditional broad market index-tracking ETFs to sector-specific ETFs that track the price of Bitcoin, cannabis stocks, airline stocks, or oil & gas stocks. More recently, the ARK ETFs led by fund manager Cathie Wood have actively invested in companies involved in cutting-edge technology and AI.

Passive investors should aim to invest in a low-cost, globally diversified, and risk-appropriate portfolio. The best way to invest like this is in a single asset allocation ETF purchased through a discount broker, or in a digitally managed portfolio through a robo advisor.

Active investing involves hands-on strategies, where fund managers or investors aim to outperform the market by picking stocks and timing trades. Passive investing, on the other hand, focuses on mirroring market performance through low-cost index funds or ETFs. While active investing seeks higher returns with more risk and fees, passive investing offers steady growth with minimal effort.

Whether to invest in active or passive funds depends on your goals, risk tolerance, and involvement. Passive funds are cost-effective, diversified, and ideal for steady, long-term growth, especially for beginners or hands-off investors. Active funds, while pricier, may appeal to those seeking market outperformance and are willing to take on higher risk. A mix can balance benefits.

Passive investing is often better than active investing due to its lower costs, consistent performance, and simplicity. Passive funds have minimal fees as they track market indexes, and research shows most active funds fail to outperform benchmarks long-term. They also offer broad diversification, reducing risk, and require less effort, making them a reliable, low-stress option for growing wealth.

An example of active investing is a mutual fund managed by a professional who selects individual stocks to outperform a benchmark like the S&P 500. Passive investing, on the other hand, includes index funds or ETFs, such as the Vanguard 500, which simply track the performance of an index, aiming to match its returns with minimal fees.