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
The Bottom Line. Passive investing is buying and holding investments with minimal portfolio turnover. Active investing is buying and selling investments based on their short-term performance, attempting to beat average market returns. Both have a place in the market, but each method appeals to different investors.
What are the pros and cons of active and passive investing? ›
Active investing
| Active funds | Passive funds |
|---|
| Pros | Potential to capture mispricing opportunities and beat the market | Convenient and low-cost way of gaining exposure to certain assets/industries |
| Cons | Fees are typically higher and there is no guarantee of outperformance | No opportunity to outperform the market |
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The Bottom Line. Passive investing is buying and holding investments with minimal portfolio turnover. Active investing is buying and selling investments based on their short-term performance, attempting to beat average market returns. Both have a place in the market, but each method appeals to different investors.
What are the 3 disadvantages of active investment? ›
However, an active investment strategy also has certain limitations like:
- More expensive: Actively buying and selling a stock or mutual fund asset adds transaction fees, making active investing costlier than passive investing.
- High tax bill: Active managers have to pay high taxes for their net gains yearly.
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. Active management portfolios strive for superior returns but take greater risks and entail larger fees.
What are the cons of active management? ›
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 advantages of active and passive? ›
Advantages and Disadvantages
In a sense this is correct – the Active voice puts the subject in the focal part of the sentence and celebrates the subject – the actor – whereas the Passive focuses on the object of the sentence – the thing being acted on.
How to tell if a fund is active or passive? ›
In general terms, active management refers to mutual funds that are actively managed by a portfolio manager. Passive management typically refers to funds that simply mirror the composition and performance of a specific index, such as the Standard & Poor's 500® Index.
What is active wealth management? ›
Active management is an approach to investing. In an actively managed portfolio of investments, the investor selects the investments that make up the portfolio. Active management is often compared to passive management or index investing. Active investors use several different techniques to choose investments.
Are active funds better than passive funds? ›
Active funds strive for higher returns and come with higher costs and risks. Passive funds offer steady, long-term returns at lower costs but carry market-level risks. Explore key differences between active and passive funds in this blog.
Once that decision has been made, there may be reasons for adopting passive investment approaches, but investors should realise that they may face unforeseen risks. These include undesirable concentrations of stocks, systemic risk and buying at too high valuations.
What is passive investment advantage? ›
Passive investing is often less expensive than active investing because fund managers are not picking stocks or bonds. Passive funds allow a particular index to guide which securities are traded, which means there is not the added expense of research analysts. Even passively managed funds will charge fees.
What are the risks of active investing? ›
Though active investing may have potential advantages over passive investing, it also comes with potential limitations to consider:
- Requires high engagement. ...
- Demands higher risk tolerance. ...
- Tends not to beat benchmarks over time.
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 the main difference between active and passive investing? ›
Active investing seeks to outperform – or “beat” – the benchmark index, while passive investing seeks to track the benchmark index. Active investing is favored by those who seek to mitigate extreme downside risk, while passive investing is often used by investors with a long-term horizon.
What is better passive or active income? ›
The work-life balance that passive income provides might be an attractive pursuit, but it's more risky than active income. Earning money from a career, side hustle or other job or business might be traditional, but in today's hustle culture, generating passive income streams is seen as equally important.
What are the pros and cons of passive real estate investing? ›
Types of Passive Real Estate Investment
- Pros: Liquidity, diversification, and regular income through dividends.
- Cons: Lower control over investment choices, subject to market volatility3.
Bottom Line. Investing in stocks offers the potential for substantial returns, income through dividends and portfolio diversification. However, it also comes with risks, including market volatility, tax bills as well as the need for time and expertise.
What is the disadvantage of passive income? ›
1) upfront Investment: Setting up passive income frequently needs an upfront time or financial investment, such as buying stocks or real estate. 2) Unpredictability: Because it may change depending on variables like market circ*mstances, interest rates, or property prices, passive income can be unpredictable.
Why is active better than passive? ›
“Active” Advantages
Flexibility – because active managers, unlike passive ones, are not required to hold specific stocks or bonds. Hedging – the ability to use short sales, put options, and other strategies to insure against losses.
