Fund A Description

Fund invests in penny stocks of companies where the CEO is a man, whose name is Chris, and has eaten a hamburger once in the past 12 months.  Positions are weighted by how many hamburgers the CEO has eaten. The management fee is 2.0% per year, plus a 5% front end load and a 0.5% 12b-1 fee.

Fund B Description

Fund invests in 490 of the S&P 500 stocks based on portfolio manager conviction.  Positions are equal weighted.  The management fee is 0.05% per year.

Which would you rather invest in?  Clearly Fund B, right?

Well, technically Fund A is passive and Fund B is active.  While this example is meant to be humorous, in reality it is not.

The lines between active and passive have been blurred to the point of being totally useless.  While passive used to mean a market cap weighted index, it no longer does.  But for some reason the SEC vastly prefers passive funds.  Did you know that passive ETFs have the ability to offer more tax efficient portfolios than active ETFs?  But it gets worse, some active ETF sponsors can offer more tax efficient ETFs than others?  The rules are absurd and create a massively unlevel playing field.  Many managers are faced with an unwinnable decision – do I violate an SEC rule, or do I violate my fiduciary duty to my client?  Hopefully the SEC will fix this huge mess that has been going on for 7+ years now with some new ETF clarifications, as the current structure only hurts the end investor.

Let’s target the importance of the conversation with this quote from none other than the creator of the index fund:

“The conflict of interest in the industry isn’t about indexing vs. active management. It’s cost.” – John Bogle