FINM7008 Chap.10 Mutual Funds, ETFs and Passive Versus Active Investing
Mutual Funds, ETFs and Passive Versus Active Investing
What funds offer and cost
Investment companies pool investors' money for diversification, management, record keeping and lower costs.
The chapter sets out the fund types, the three kinds of fee and the expense ratio, and shows how a small annual cost difference compounds.
Passive or active
It then reviews the lecture's evidence from the United States, Australia and China, and how passive funds and ETFs came to hold most US equity-fund assets.
Linking it to the CAPM
If the market portfolio is the best risky portfolio, the cheapest way to hold it is through an index fund or ETF.
The chapter ties that conclusion to products and costs, and uses the lecture's Australian figures, including superannuation fees, to show what a gap of less than one percentage point a year does over a working life.
What this chapter covers
- 01
Services of investment companies
- 02
Types of investment company
- 03
Operating expenses and loads
- 04
The expense ratio and net return
- 05
Exchange-traded funds
- 06
Fee drag over long horizons
- 07
Active versus passive evidence
Worked example · free
Thirty years of fee drag
- 1Net returns: 7% − 0.228% = 6.772% and 7% − 0.906% = 6.094%.
- 1Balances: $100,000 × 1.0677230 = $714,038 and $100,000 × 1.0609430 = $589,827.
- 1Difference: $124,211, about 17.4% of the cheaper fund's balance.
Key terms
- Front-End Load
- A fee paid when buying shares in a mutual fund.
- Back-End Load
- A fee paid when redeeming shares in a mutual fund.
- Exchange-Traded Fund
- A fund, usually tracking an index, whose shares trade on an exchange throughout the day.
- Index Fund
- A fund built to replicate the return of a chosen share market index.
- Expense Drag
- The reduction in a fund's long-run balance caused by compounding its annual costs.
Mutual Funds, ETFs and Passive Versus Active Investing FAQ
Do active funds beat index funds after fees?
On the lecture's evidence, generally not. From 1971 to 2020 the US equity index beat the average active fund in 30 of 50 years and by 0.96% a year after fees, and Australian active funds trailed passive ones by 1.70 points a year over five-year periods.
How do ETFs differ from mutual funds?
ETFs trade on an exchange like shares, so investors can buy and sell them throughout the day, while mutual fund units are bought and redeemed through the fund. Index-tracking ETFs, such as those following the S&P 500, dominate the ETF market.
Where has active management done better?
The lecture's example is China, where active equity funds historically outperformed the main indexes in a market dominated by retail traders, by exploiting behavioural mispricing. That advantage has compressed as the market has become more institutional.
What is an expense ratio?
It is a fund's total annual operating expenses divided by its total assets, the yearly cost of owning the fund. The investor's net return is the gross return minus the expense ratio, so a higher ratio lowers every year's return before any loads are counted.
What are the main types of investment company?
The lecture lists unit investment trusts, managed investment companies, which are either open-end or closed-end funds, and exchange-traded funds, plus other organisations such as commingled funds, real estate investment trusts and hedge funds.
How large is the passive share in Australia?
Smaller than in the United States. The lecture puts passive funds at about 18% to 22% of Australian equity fund assets, because superannuation funds, which dominate the managed-fund industry, often pick stocks through their own internal teams.
Exam move
Learn the three fee types and the expense ratio, then compute a one-year net return with a load and a long-horizon fee comparison. Summarise the evidence in three numbers you can quote. Close by explaining why passive funds can hold most equity-fund assets yet own only a minority of all shares. Learn the three costs by when they are paid: loads at entry or exit, the expense ratio every year the money stays in the fund.
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