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Active vs. Passive Investing: Explained

Updated: Mar. 30, 2022By: Michelle Jones

When you're thinking about active vs. passive investing, it's important to realize that there are benefits to each. Active investing requires someone to actively manage a fund or account, while passive investing involves tracking a major index like the S&P 500 or another preset selection of stocks. Find the out more about each, including their pros and cons, below.

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What is Active Investing?

Active investing involves taking a hands-on approach by a portfolio manager or some other market participant who makes decisions about where to invest the money in the fund. Active management aims to outperform indices like the S&P 500 or whatever other benchmark is used by the fund. Every fund manager chooses a benchmark that contains the type of investments their fund contains.

Active management requires a deep understanding of the markets and how assets move based on what's happening in the economy, the rest of the market, politics, or other factors. Portfolio managers use their experience, knowledge, and analysis to make choices about what to buy or sell in the portfolio.

Some examples of actively managed investments are hedge funds and a stock portfolio actively managed by the investor via an online brokerage account.

What is Passive Investing?

Passive investing involves investing over the long term with very limited buying and selling. It focuses on a buy-and-hold strategy, although you can also follow such a strategy with active investing. Passive investments often track an index like the Nasdaq 100, which means that when a stock is added to or removed from the index, the index fund automatically buys or sells that stock.

Passive investments generally don't outperform the market, but rather, perform in line with the market. This means that when the stock index the fund is tracking has a difficult year, your portfolio does too.

Some examples of passive investments include exchange-traded funds that track an index like the S&P 500 (SP500) or Dow Jones Industrial Average (DJI) or mutual funds.

Tip: Active investing involves actively choosing stocks or other assets to invest in, while passive investing limits selections to an index or other preset selection of investments.

Active vs. Passive Management Fees

One big difference between the two is the expense. Unless you are picking the stocks yourself through an online brokerage account, actively managed funds are much more expensive than passive funds that track an index.

A traditional fee structure from actively-managed hedge funds looks like the following:

  • Management fee: 2%
  • Performance fee: 20%

The performance fee is calculated based on the increase in the net asset value of the client's holdings in the fund, which is the value of the fund's investments. For example, an investor might own $1 million worth of shares in a hedge fund, and if the fund manager increases the value by $100,000, the investor would pay $20,000 or 20% of the increase.

However, some actively managed mutual funds charge only a management fee, although that fee is still higher than the fees on passive funds. Many funds have reduced their fees in recent years to remain competitive, but they are still more expensive than passive funds. Thomson Reuters Lipper found the average expense ratio for an actively managed stock fund to be 1.4% but just 0.6% for the average passive fund.

Active vs. Passive Investing: Pros and Cons

There is much debate about active vs. passive investing and which one is better, but in reality, a combination of both strategies may offer more portfolio diversification. However, there are some advantages and disadvantages of both types of investing.

Pros of Active Investing

  • More customization: can contain investments the manager chooses
  • Ability to drop stocks/sections: active accounts give investors or managers the option to exit stocks or sectors that aren't performing well.
  • Higher potential to outperform the market: managers aim to outperform the market through stock picking

Cons of Active Investing

  • More expensive than passive accounts

Pros of Passive Investing

  • Less expensive: lower fees than active accounts
  • Transparency: it's always clear what stocks are in the fund since it's tracking an index or a preselected group of stocks.
  • Less Capital Gains Tax: when you buy and hold stock, your capital gains will be less in the short term, which means less tax in the short term

Cons of Passive Investing

  • Less flexibility in fund/stock selection: limited to a certain index or preset selection of investments without any variance.
  • Don’t typically outperform the market: because they are tracking a major stock index.

Should you Choose Active or Passive Investing?

For the average investor, passive investing might work better because of the lower fees and the fact that you don't have to make decisions about which stocks to buy or sell. Multiple studies spanning decades have demonstrated that in the long run, passive investing beats active.

However, you may prefer to actively invest during a bear market because active managers don't have to stick with a certain set of stocks in a particular index. They may be able to find pockets of outperformance in various parts of the market, while the index-tracking funds will have to stick with a wide array of stocks in every sector across the market.

Tip: In general, passive investments do better during a bull market because it's difficult for hedge fund managers to outperform major indices.

High-net-worth individuals, or those with at least $1 million in liquid financial assets, may prefer to invest with actively managed funds because fund managers aim to protect wealth during times of economic downturn.

Combining Active & Passive Investing

The real question shouldn't be about choosing between active vs. passive investing, but rather, utilizing a combination of both if you have enough assets to do so. Since passive investing often performs better during bull markets and active investing can outperform in bear markets, the best course of action may be to combine the two, which gets you the best of both worlds.

Bottom Line

The debate over active vs. passive investing has been heated for many years, but there are advantages and disadvantages to both. Active investing involves actively choosing stocks or other assets to invest in, while passive investing limits selections to an index or other preset selection of investments.

Fees on active investments are higher than those on passive investments because it costs more to actively manage investments. One example of an active investment is a hedge fund, while an exchange-traded fund that tracks an index like the S&P 500 is a passive investment.

In general, passive investments do better during a bull market because it's difficult for active fund managers to outperform major indices. However, when the market is in decline, active investing often shines because investors have a wider array of investments to choose from, which enables them to exclude sectors or stocks that are expected to underperform.

This article was written by

Michelle Jones profile picture
Michelle Jones is editor-in-chief for ValueWalk.com and a daily contributor for ValueWalkPremium.com and has been with the sites since 2012. Previously, she was a television news producer for eight years. She produced the morning news programs for the NBC affiliates in Evansville, Indiana and Huntsville, Alabama and spent a short time at the CBS affiliate in Huntsville. She lives in the Chicago area with her son, dog and two cats.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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