Shock and awe! In 2018, Vanguard Canada, a fervent advocate of passive management, launched traditional, actively managed mutual funds. Actively managed mutual fund companies also successively launched their own array of exchange traded funds (ETFs). As a result, the great majority of the Canadian market’s 33 suppliers now offer mainly active management. Are we looking at the end of passive ETFs?

Don’t lose sleep over their disappearance. Passive ETFs still account for the lion’s share of the Canadian market. For example, 21 of the 25 biggest ETFs are passively managed. But still… With actively managed funds invading the ETF market, some of them with more competitive fees than ever, we need to ask ourselves a few questions.

Investors often point to the modest fees to justify investing in passive funds. For instance, Canadian actively managed mutual funds often post sky-high management expense ratios (MERs) of 2% to 2.50%. At the same time, you can invest in a passive ETF emulating the S&P/TSX Composite Index with a tiny MER of 0.06%. But given the availability of a growing number of active ETFs with more affordable MERs, some investors are wondering why not get the best of both worlds, with the possibility of higher returns and reasonable fees. Is this the way to go?

Personally, I still think that a well designed, low-cost, passive fund remains the best choice.

First, even though it’s true that many active ETFs charge fees well below those of equivalent mutual funds, their fees generally remain above 0.50%, which is expensive compared with the best passive ETFs.

Second, if you think that fees are the only factor behind actively managed funds’ lower returns, you may be wrong. In a devastating report, Standard and Poor’s shows that equity mutual funds available in the United States do not outperform their benchmark index in terms of either gross or net-of-fees returns. More specifically, over a 10-year period, actively managed equity funds failed the test in 16 out of 17 categories!

Third, active managers tend to behave “actively”, i.e., to carry out a large volume of transactions. These numerous transactions generate commissions that enrich investment banks at investors’ expense. Passive fund managers, on the other hand, only try to “mimic” the market. They conduct a small number of transactions, charge frugal commissions and trigger few taxable capital gains distributions.

Fourth, high-quality passive funds are predictable: investors know in advance that they’ll earn more or less the market return. And while the market is highly unpredictable in the short term, investors can have a pretty good idea of its expected return in the very long term. In contrast, active funds — especially those with a high Active Share index — offer a much less predictable long-term return: they can substantially outperform the market, but they can also tank.

Fifth, I find that passive funds are better suited to financial planning. Let’s be honest. Not many people invest just for fun. To the contrary: they have a prime objective, and in many cases it’s financial independence. But there are a lot of hurdles along the way to meeting this goal. Life is full of surprises: loss of a job, health problem, birth of twins, etc. All of these unforeseen events have an impact on our ability to save, invest and prepare for the future. In this context, active management adds another layer of uncertainty, as the long-term returns are less predictable than for passive funds.

Sixth, passive funds protect investors against “manager drift”. In some cases, Canadian equity funds contain a good share of U.S. equities. Or cash. Personally, I hate this trend. If I invest in a Canadian equity fund, it’s because I want Canadian equities. It seems obvious. Would you buy a tube of toothpaste containing 20% sunscreen? By contrast, a good passively managed ETF always does what it’s supposed to do, namely replicate the market index specified in its investment policy.

Finally, with passive funds, there are no excuses for poor returns. If a passive fund doesn’t reproduce its benchmark, you can flush it without hesitation. In the case of an active fund, however, one or more disappointing years can always be explained away by the (true) fact that no strategy can reasonably promise to outperform the market every year.

To wrap up, in my opinion, even with equal fees, there’s no reason to hesitate: the best passive funds are clearly the right choice for investors who want to look ahead and build wealth!