Active investors make affirmative decisions as to which stocks, bonds and other investments to buy, sell or hold at any point in time. They seek out investments that they think might outperform and that fit their investing style. There are mutual funds and ETFs that invest in an active fashion as well. In a nutshell, active investors are trying to outperform the market.
Passive investors generally invest via index mutual funds or ETFs that passively track an index like the S&P 500, a total stock market index or others. Passive investors generally are trying to match the performance of the market, not to beat it.
Note that investors can engage in both active and passive investing inside of their portfolio. They may use passive index funds as the core of their portfolio and may add active holdings to try and enhance their returns.
What is passive investing?
Passive investing is a hands-off investing strategy where an investor seeks to replicate the performance of one or more market indexes or one or more segments of the market. Passive investors are looking to match the market’s performance in those areas where they are using passive investments.
Passive investing is generally done by investing in index mutual funds or ETFs that track a market index or segment. Passive investing is generally a long-term investing approach and passive investors generally are not concerned with the day-to-day fluctuations in the markets.
Passive investing generally doesn’t require daily monitoring. There are generally fewer transactions with passive investing versus active investing. This usually means lower transaction costs and fewer taxable transactions in taxable accounts.
What is active investing?
Active investors are trying to beat the market through actively buying and selling stocks and bonds, or investing in mutual funds and ETFs that have an active investing style designed to try and beat the market.
Active investors often trade frequently and try to time their trades to beat the market. Active investors can buy or sell individual stocks and bonds themselves, or they can delegate this to the managers of active mutual funds and ETFs.
Active fund managers will typically use a strategy to determine which stocks to buy and sell, and the timing of those transactions. Active funds can invest across various categories of stocks and bonds.
Active investing requires constant attention from investors and fund managers; ignoring their investments for even a short period of time can result in exposure to extreme market volatility and potential losses in their portfolio.
Active investing generally entails higher transaction costs than passive investing. For those who are successful, this also means higher capital gains taxes in taxable accounts and greater investment losses for those active investors who are not successful. This also applies to actively managed mutual funds and ETFs. What’s more, these funds generally have higher expense ratios than passive index funds.
Differences between active and passive investing
There are a number of differences between active and passive investing.
| Active investing | Passive investing | |
|---|---|---|
Choosing investments | Active investors actively look for stocks and bonds to buy and sell based on their investing objectives and strategies. This applies to the managers of actively managed mutual funds and ETFs. | Passive investors seek to replicate the performance of a market index or benchmark. Often this involves the use of index mutual funds or ETFs that track one or more market benchmarks. For example there are funds that track the S&P 500 and other market indexes. |
Taxes | Active investing may tend to generate a large tax bill in the form of capital gains due to the more frequent transactions that are often involved. | Passive investing tends to result in a lower tax bill since trades are not made as frequently as with active investing. |
Cost | Active investing is generally more costly. Active mutual funds tend to have higher expense ratios compared with index funds. Active investing also may result in higher transaction costs due to more frequent trading. | Passive investing through index mutual funds and ETFs tends to result in lower costs for investors. |
Pros and cons and active and passive investing
Active and passive investing both have a number of pros and cons. Additionally, investors can mix both styles in building a portfolio if they feel this is appropriate for them.
Active investing pros:
- Flexibility. Active investors and fund managers are not tied to a specific index or limited to a specified pool of stocks or bonds. Investors can move to any stocks they see as having potential.
- Expanded trading options. Beyond just long investing in individual securities or funds, active investors can use tools such as stock options, stop orders and shorting stocks or ETFs in their investing strategy. While the ability to use more trading techniques can expand an investor’s strategy options, they also tend to add risk to the portfolio and should be used carefully.
- Tax management options. Techniques such as tax-loss harvesting can be used to realize losses that can be used to offset capital gains realized during the year. Tax-loss harvesting can be used with a passive investing portfolio, however it is often more likely that you will have losses to realize as an active investor.
Active investing cons:
- Higher fees and expenses. Active investing can often result in higher trading costs due to a generally increased level of transactions with this style of investing. In the case of active mutual funds and ETFs, these funds generally have higher expense ratios than their passive counterparts.
- Increased risk. Trying to beat the market carries potential risks. If you bet the wrong way, so to speak, you may underperform the market. If this occurs during a bear market, active investors run the risk of losing more than the market during these periods. Borrowing money on margin to execute a trading strategy can lead to substantial losses.
Passive investing pros:
- Lower expenses. Since most passive investors use index mutual funds and ETFs these funds tend to have lower expense ratio than actively managed funds. A passive strategy will generally involve fewer transactions than active management and hence costs will be lower there as well.
- Outperformance. Over time, equity index funds have tended to outperform their actively managed peers. While this outperformance was not as great in 2022 as in many prior years, S&P Global indicates that most domestic equity index funds have outperformed their active peers over the past decade.
- Transparency. Index funds generally just track the stocks or bonds that comprise the underlying index. Actively managed fund managers typically do not disclose their fund’s holdings except as required during the year.
- Increased diversification. Index funds will consist of the full range of stocks or bonds that comprise the fund’s underlying index offering an inherent level of diversification. Active investors, especially those using individual stocks and bonds to implement their strategy, will often have a much higher level of concentration in their portfolio increasing their risk.
Passive investing cons:
- Average returns. By design, passive investing is designed to provide average returns in terms of closely tracking the index(es) tracked by the passive index funds used in the portfolio. Average returns are often better than the performance of actively managed portfolios, but passive investing is not a path to outperformance in terms of beating the markets.
- Not glamorous. While returns from passive investing have often been quite solid, this is not the path for investors that are looking for the next penny stock that will increase a hundredfold in value.
When is each style appropriate?
Passive investing tends to be a low maintenance, long-term proposition. This investing style, using index funds and ETFs, can be appropriate for investors who are not well-versed in choosing individual stocks and who are looking for a way to be diversified without having to choose individual securities.
Active investing is more geared to experienced investors who want to try to beat the market via choosing individual securities and buying and selling them when deem it appropriate. Active mutual funds can offer a means to try to best the market if the fund manager’s strategy pans out.
Frequently asked questions (FAQs)
Are mutual funds active or passive?
There are both active and passive mutual funds. Actively managed mutual funds seek to outperform the market as a whole or a segment of the market. Managers of active funds make decisions as to which stocks or bonds to buy, hold or sell over time.
There are also a large number of passive mutual funds that track an index like the or the Russell 2000 (small cap stocks). The managers strive to replicate the performance of the fund’s underlying index and the holdings of the index.
What is an example of a passive investment?
The Vanguard S&P 500 ETF is an example of a passive ETF. It is designed to track the holdings and the performance of the S&P 500 index. The fund’s managers do not make investing decisions based on any criteria other than doing what is needed to replicate the performance of the index.
Can I combine both active and passive investing in my portfolio?
Investors can certainly combine the use of both active and passive investments in their portfolio. For example, an investor might build a core group of holdings based on an asset allocation strategy that is composed of index mutual funds and/or ETFs.
They might then add a number of active investments in the form of active mutual funds, individual stocks or both in an effort to add an additional level of return to their portfolio.
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