Active vs. Passive Investing: An Easy-to-Follow Guide for First-Time Investors

There’s been a long-raging debate about the merits of two different wealth management styles: active vs. passive investing. Either strategy can be used to manage a mutual fund, but there’s a pretty substantial difference between how each works.

When it comes to investing money, the type of portfolio you choose can have a meaningful impact on your long-term fees and investment results. So which type is the best option for you? Let’s break down active and passive investing and discuss where and when one — or the other — may be a better fit.

Active vs. passive investing: what’s the difference?

At the most basic level, active and passive investing can be summed up like this:

Actively managed funds aim to beat the market, whereas passively managed funds plan to match market movements, instead. Still, there’s much more to how these portfolios are managed, their investment philosophies, and how much each one generally costs.

Let’s take a deeper look.

What’s an active investment portfolio?

An actively managed portfolio is a pool of different investments that are bought and sold by professional investors, or portfolio managers. The portfolio managers evaluate and select which individual stocks, bonds, or other investments should be added or removed from the portfolio, and under which conditions. Shares of the entire portfolio are bought and sold as one investment.

Each portfolio has an underlying investment philosophy — like to select large U.S.-based company stocks that the portfolio managers think can outperform the large-cap U.S. stock market, in general. A common investment strategy is to aim to beat a particular asset class, such as real estate, foreign stocks, or U.S.-based corporate bonds.

How can portfolio managers know if they’ve met that goal? They track their portfolio’s performance against a benchmark, or index, for the slice of the market they aim to beat. A common benchmark for large-company stock portfolios is the S&P 500 Index, which tracks the 500 largest publicly-traded companies in the U.S.

Actively managed portfolios are often attractive to investors who think their fund managers can beat the market, and who are willing to pay the investment management fees that come with more active strategies.

What is a passive investment portfolio?

A passively managed portfolio, meanwhile, aims to track a particular slice of the investable universe. Like its actively-managed counterpart, a passive portfolio is also made up of a pool of securities that meet a particular investment goal. Where the portfolio differs, however, is in how that portfolio is managed.

In terms of asset allocation, a passive fund seeks to own all the stocks, bonds, or other assets within a particular market index, like the S&P 500 or Dow Jones Industrial Average, for example. A passive fund will track index movements, and coordinate buy-and-sell decisions as securities are added or removed from the index.

In general, it’s less labor-intensive to manage a passive portfolio. A passive investment fund doesn’t need to employ the high-cost investment analysts and portfolio management teams that are often required to make active buy and sell decisions. Passive managers also buy and sell investments less frequently, which means they can benefit from decreased trading costs.

In the end, it’s the mutual fund or exchange-traded fund (ETF) investor — like you — who benefits from the lower fees associated with a passively managed portfolio. Active portfolio managers, meanwhile, are tasked with beating their slice of the market even after the net loss effect of those additional fees are added to the portfolio’s performance numbers.

Passive portfolios are often attractive to cost-conscious investors who aim to reduce fees.

Active investing: the pros and cons

Active investment portfolios are the granddaddy of the mutual fund world. These time-tested, manger-led portfolios have been around for nearly a century, and they make up the majority of mutual fund offerings today. Still, this portfolio type does have some inherent advantages and disadvantages. Let’s take a look at each.

Advantages of active investing

• Enhanced flexibility: Active managers aren’t required to hold specific stocks or bonds, unlike their index-tracking cousins. That means that an actively managed fund, even one that tracks a particular asset class, can avoid a certain company or even an entire asset class if it doesn’t view its addition as a strong fit.
• Ability to hedge against risk: Active fund managers often have more tools in their tool belt, which can come in handy when looking to insure against potential portfolio loss. Active managers can hedge their bets with derivative investments (options and futures, for example), where a loss in one investment area can be offset by a gain in another.
• Increased potential for risk management: Being about to move in and out of certain market sectors and specific holdings can help reduce a portfolio’s overall risk structure if a certain allocation grows too large.
• Can make tax-managed investment decisions: Active managers can take advantage of tax-loss harvesting opportunities by selling underperforming investments to offset the capital gains tax from higher-performing securities.

Disadvantages of active investing

• It’s expensive. The fee structure for an actively managed fund is substantially higher than that of a passively managed fund, sometimes by as much as a few percentage points. Over time, those fees can eat away at a fund’s performance, creating a huge hurdle for an active manager to overcome, just to keep pace with their passively managed competitors.
• Many portfolios don’t outperform over a longer period of time. Despite the highly skilled team of investment professionals at the helm, fewer than one in four actively managed funds were able to beat the returns of their passive peers over a recently reviewed 10-year period.

Passive investing: the pros and cons

The first passively managed index fund was launched in 1975 by Vanguard founder Jack Bogle. Since then, passive funds have become increasingly more popular among individual investors, particularly those looking for easy and inexpensive access to the market.

Advantages of passive investing

• Very low fees: The lower the fee structure of a fund, the more of the return the investor ultimately gets to keep. Expense ratios as low as .2% (and sometimes even lower) make it hard for high-cost active portfolios to come close — or even outperform —  lower-cost passive funds.
• Transparent management: It’s easy for a passive investor to know what’s in their index fund’s portfolio at any time — it’s basically whatever is in the index it tracks. Actively managed mutual funds generally offer this information just twice a year in their annual and semi-annual shareholder reports.
• Tax-efficient by nature: Passive funds don’t trigger as many taxable events, purely because the portfolios are traded at a much less frequent rate than their active counterparts.
• They’re more likely to outperform active funds: Even though the goal of passive funds is merely to match market performance, the low-cost fee structures often give them an advantage over their actively managed peers. In short, it’s hard to pick a portfolio that can consistently beat the market while also overcoming the high-cost barrier most active portfolios endure. As it turns out, most can’t do it.

Disadvantages of passive investing

• Some asset classes perform better under active management. There are a few corners of the market in which actively managed funds have recently outperformed their passively managed rivals. Those areas include emerging markets, international stocks outside the U.S. and Canada, and bond portfolios. These are areas in which it may make sense to seek out active portfolio management.
• You can’t control portfolio assets. A passive portfolio doesn’t leave room for personal preference when it comes to security selection. That means you can’t avoid stocks whose corporate policies you disagree with — or load up on extra shares of those you really love. (At least, not within the confines of the fund portfolio.)

How to start investing

A hands-on financial planner can work with you to tease out your risk tolerance, hone your investing goals, and create a long-term plan to help you reach your personal finance goals. Or if you’d rather create a do-it-yourself financial plan, use one of our handy guides to help find the best investment app or robo-advisor for you.

Either way, there are plenty of tools available to help you learn about the market, decide what you want to invest in, and choose a platform that meets your needs.

FAQs about active vs. passive investing

Before you start investing, take a quick look through these most frequently asked questions about active and passive investing strategies. We’ll walk you through the ins and outs of each to make sure you have all the tools you need before you start investing.

The bottom line

Research has found that passive portfolios tend to perform better than active portfolios, particularly over longer periods of time, but that’s not always the case. Active managers in some market sectors — like emerging markets or small-cap stocks — are sometimes better positioned to outperform their passively managed peers.

Index funds can be an easy, low-cost way for a beginner to enter the market, but, over time, it may be worth exploring more complex options, like an actively managed fund. Either way, a financial advisor can help you find your footing if you’re not ready to get started on your own.