The differences between passive and active management start with an investment index, or benchmark, such as the S&P 500.
The manager of a passive mutual fund or exchange traded fund (ETF) will seek to achieve the return of a particular index, before expenses – nothing more, nothing less. Typically, passive funds own most of the same securities, and in the same weightings, as their respective indices. Passive fund managers make no active decisions, potentially resulting in less trading – which reduces fund expenses as well as potential taxable distributions to shareholders. The performance of a passive fund should mirror the index it’s tracking, which means that the fund will share both the ups and the downs of the index.
This type of simplicity means that many investors feel more comfortable with passive funds as they know what they’re getting – an investment that tries to follow an index. However, a risk of passive investing is concentration. Although markets contain a wide range of companies, they are concentrated towards the very largest. In some cases indices are over-exposed to one or a small number of stocks or sectors that have a large impact on performance. For example, in the 1990s, technology and telecoms stocks became a large part of the FTSE 100; index funds benefited from their growth until their subsequent spectacular decline; financials then became dominant; and then mining shares featured heavily.
In contrast, an active manager will seek to outperform an index by achieving higher returns or taking lower risk, or by combining these two techniques. Because active fund managers choose investments, they have the potential to outperform the market on the upside and limit losses when the market declines, relative to the index. They seek to do this by using their knowledge and skill to analyse the market (hence the higher fees). Then they buy shares (equities) which they believe are presently undervalued, and so have potential to increase in price – or pay increased dividends – over time. This process is known as stock-picking. Managers can also adjust their portfolios to minimise potential losses. However, there is no guarantee that actively managed funds will outperform the index.
Pros of Passive Investments
•Likely to perform close to index
•Generally lower fees
•Typically more tax-efficient
•Simplicity: investors know what they are getting
Cons ofPassive Investments
•Unlikely to outperform index
•Participate in all of index downside
•Buy/sell decisions based on index, not research
Pros of Active Investments
•Opportunity to outperform index
•Potential for limiting the downside
•Buy/sell decisions based on research
Cons of Active Investments
•Potential to underperform index
•Generally higher fees
•Typically less tax-efficient
FAQs
Passive investing targets strong returns in the long term by minimizing the amount of buying and selling, but it is unlikely to beat the market and result in outsized returns in the short term. Active investment can bring those bigger returns, but it also comes with greater risks than passive investment.
What are the pros and cons of active and passive investing? ›
Passive investing targets strong returns in the long term by minimizing the amount of buying and selling, but it is unlikely to beat the market and result in outsized returns in the short term. Active investment can bring those bigger returns, but it also comes with greater risks than passive investment.
What is the difference between active and passive wealth management? ›
Key Takeaways. Active management requires frequent buying and selling in an effort to outperform a specific benchmark or index. Passive management replicates a specific benchmark or index in order to match its performance.
What are the disadvantages of active investment management? ›
Disadvantages of Active Management
Actively managed funds generally have higher fees and are less tax-efficient than passively managed funds.
What is the difference between active and passive fixed income asset management? ›
Active management is overseen by investment professionals striving to outperform specific benchmarks. Passive management (i.e., index ETFs, index funds) attempts to replicate the return pattern of a specific benchmark.
What are the pros and cons of active active vs active passive? ›
Active-active offers unparalleled scalability and fault tolerance, making it ideal for applications demanding continuous high performance. On the other hand, active-passive, with its simplicity and cost-effectiveness, suits scenarios where reliability and failover efficiency are paramount.
Why is passive better than active? ›
Among the benefits of passive investing, say Geczy and others: Very low fees – since there is no need to analyze securities in the index. Good transparency – because investors know at all times what stocks or bonds an indexed investment contains.
Why do people invest in actively managed funds? ›
Active ETFs are growing faster than the broader industry, as choice and adoption have expanded. Traditional active ETFs retain the benefits of the ETF wrapper, such as transparency and trading flexibility, with no visible sacrifice on alpha. Active ETFs also offer improved tax efficiency over active mutual funds.
Are actively managed accounts worth it? ›
Actively Managed Funds Can Charge Higher Fees
If the fees and expenses associated with an actively managed investment are high, it may be more difficult for the portfolio to outperform a benchmark or index, and you may end up with lower returns as a result.
Which has higher fees, passive or active investing? ›
Active investing strategies often come with higher expenses for manager skills and involvement. Over the past decade, inflows have tilted toward passive funds as investors seek out cost-effective and broad market exposure.
Active management has benefits, such as the potential for higher returns, the ability to adjust to market conditions, and the opportunity for diversification. However, active management also has drawbacks, such as higher fees, difficulty in consistently outperforming the market, and the risk of human error.
What are the problems with passive investing? ›
The Danger of Passive Investing for Markets
That is, in a market downturn, there may be a rush for the exits as both passive and active investors get out of large cap stocks. This may become even more of an issue as passive funds continue to take market share from active peers.
Is passive portfolio management better than active portfolio management? ›
Advantages of Passive portfolio management:
Low Costs: Passive portfolio management typically involves lower fees and expenses compared to active management since trades are limited in nature and analysis is only to the extent of what is comprised in the benchmark index - so transaction costs are minimal.
What is better active or passive funds? ›
For example, when the market is volatile or the economy is weakening, active managers may outperform more often than when it is not. Conversely, when specific securities within the market are moving in unison or equity valuations are more uniform, passive strategies may be the better way to go.
What is better passive or active income? ›
While active income can give stability, passive income builds a safety net that can help you achieve financial independence sooner. Plus, having both types of income could lead to opportunities for further wealth generation, empowering you to live the lifestyle you desire while also saving for the future.
What is the difference between active and passive management in Fidelity? ›
Passively managed ETFs attempt to closely track a benchmark (such as a broad stock market index, like the S&P 500), whereas actively managed ETFs intend to outperform a benchmark. There are 2 types of actively managed ETFs—traditional actively managed ETFs and semi-transparent active equity ETFs.
What are the pros and cons of active and passive listening? ›
Passive listening can erode trust and respect by signaling a lack of interest in the needs and concerns of the team. Active listening, on the other hand, demonstrates respect, empathy, and a genuine interest in understanding and valuing others' perspectives.
What are the pros and cons of investing? ›
Pros and Cons of Investing
The primary advantages of investing are the opportunity to grow your principal and earn passive income. Unfortunately, these benefits come with the possibility of losing some or all of your principal. In addition to the downside exposure, many investment instruments are inherently complex.
What is the pros of passive? ›
What are the pros of passive investing? Unlike an active investment strategy, which may or may not beat the market and can be expensive to maintain, a passive investing strategy is typically less risky and less expensive in comparison.
