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? ›
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 disadvantages of passive investment? ›
The downside of passive investing is there is no intention to outperform the market. The fund's performance should match the index, whether it rises or falls.
What is the difference between active and passive fixed income asset management? ›
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 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.
Advantages of Passive Investing
- Steady Earning. Investing in Passive Funds means you're in it for a long race. ...
- Fewer Efforts. As one of the most known benefits of passive investing, low maintenance is something that active investing surely lacks. ...
- Affordable. ...
- Lower Risk. ...
- Saving on Capital Gain Tax.
While actively managed assets can play an important role in a diverse portfolio, Wharton faculty involved in the program say that even large investors often do best using passive investments for the bulk of their holdings.
Which is better active or passive portfolio management? ›
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 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.
These include undesirable concentrations of stocks, systemic risk and buying at too high valuations. Investing passively should not be seen as a low governance 'set-and-forget' option. While it is no panacea, active management can overcome some of these issues.
What are 5 cons of investing? ›
While there are some great reasons to invest in the stock market, there are also some downsides to consider before you get started.
- Risk of Loss. There's no guarantee you'll earn a positive return in the stock market. ...
- The Allure of Big Returns Can Be Tempting. ...
- Gains Are Taxed. ...
- It Can Be Hard to Cut Your Losses.
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 management better than passive? ›
Market corrections are a regular and unavoidable part of market cycles. Active management has typically outperformed passive management during market corrections, because active managers have captured more upside as the market recovers.
How often do actively managed funds outperform passive funds? ›
Only one out of every four active funds topped the average of their passive rivals over the 10-year period ended December 2022. But success rates vary across categories. Long-term success rates were generally higher among bond, real estate, and foreign-stock funds, where active management may hold the upper hand.
Do wealth managers outperform the market? ›
Less than 10% of active large-cap fund managers have outperformed the S&P 500 over the last 15 years. The biggest drag on investment returns is unavoidable, but you can minimize it if you're smart. Here's what to look for when choosing a simple investment that can beat the Wall Street pros.
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.
Which is better, passive or active investing? ›
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 are the advantages of active investing? ›
Flexibility. Active managers can buy stocks that may be undervalued and underappreciated in the general market. They can quickly divest themselves of underperforming stocks when the risks become too high. They can choose not to invest during certain periods and wait for good opportunities to buy.
What are the pros and cons of investing? ›
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.
