Active versus index investing

When you start taking an interest in the stock market, it is easy to feel overwhelmed by the number of ways to invest. Every financial institution has products to offer. Every book has a method for analyzing the market. Even your brother-in-law has an opinion.

Fortunately, investment funds can be divided into two broad types: actively managed funds and index funds. The crowded shelf becomes much easier to understand once you see those two categories.

With active investing, a manager chooses which investments to buy and sell. The usual goal is to earn a better return than the market. If the Canadian market returns 7%, for example, an active investor hopes to earn more than 7%.

Index investing has no ambition to beat the market. Its goal is to follow a market index as closely as possible. Instead of asking a manager to choose the winners, an index fund owns the investments selected by the index rules.

An index is simply a measure of a market. A Canadian stock index, for example, follows a group of companies listed in Canada. The guide to how index investing works explains how those companies are selected and weighted.

Which approach is better depends on who is asking. Active management gives institutions and advisers more fees to collect. For the investor, a broad, low-cost index fund is the sensible default. It provides diversification, keeps costs low, and does not require you to identify the next winning manager.