Active vs. Passive Funds: Benefits & Differences (2024)

Active vs. Passive Funds

Actively-managed funds and passively-managed funds can share some basic similarities, such as fund type, structure, diversification, other benefits and general investment objective (for example, technology sector growth). However, there are significant differences between active and passive funds, such as management style, cost, tax-efficiency, and performance goal.

Similarities of Active & Passive Funds

• Active/Passive Flexibility: Both mutual funds and exchange-traded funds can employ active or passive investing. The mutual fund industry is largely known for active management, although index-based mutual funds are available. ETFs are predominantly passively-managed and hedge funds are almost always actively managed.
• Structure: Whether a fund is actively-managed or passively-managed, it's still an investment fund where the manager uses pooled money from investors to buy and sell investment securities, such as stocks, bonds, or other assets, to be held in the fund. The investors then share in any returns that the fund generates.
• Benefits: Because they share the same general structure, active and passive funds share similar benefits, such as diversification and professional management.
• Investment objective: Actively-managed funds and passively-managed funds can share the same objective, such as growth, income, or capital preservation. Active and passive funds can also both represent the same fund category, such as a specific geographic area or market capitalization.

Important: Since they commonly seek to passively track the performance of a benchmark index, most passive funds are index funds. However, not all index funds are passively-managed. Because of this slight distinction, the terms "passive fund" and "index fund" are not completely interchangeable terms."

Differences Between Active & Passive Funds

• Management style: The primary difference between active and passive funds is how the funds are invested and managed. For example, an active fund manager has discretion in security selection, as well as the timing of trades. In contrast, most passive fund managers can only buy and hold the securities that are in a benchmark index, such as the . Index fund managers must also passively hold the securities at roughly the same weighting as the index. Some active funds might also hold only S&P 500 stocks but their managers can use discretion in which stocks to buy, which to avoid, and how to weight the holdings.
• Costs: Actively-managed funds generally have higher costs, measured by an expense ratio, than passively managed funds. This is because active management generally requires more research, analysis, and trading compared to passive management. Expense ratios for actively-managed mutual funds typically range from about 0.3% to 0.7%, but can cost even more than that. Expense ratios for index funds and ETFs typically range from about 0.03% to 0.20%.
• Tax-efficiency: Since actively-managed funds tend to have higher turnover (more buying and selling of securities in the fund), they tend to generate more capital gains distributions to shareholders compared to passively-managed funds. Tax-efficiency is more of a concern with taxable brokerage accounts while tax-advantaged accounts, such as traditional IRAs or 401k plans can shelter the distributions that are normally taxable.
• Performance goal: Actively-managed funds generally attempt to outperform a broad market index; whereas passively-managed funds generally attempt to match the performance of a benchmark index, less management fees. For example, an actively-managed large-cap stock mutual fund would typically attempt to outperform the S&P 500. A passively-managed S&P 500 index fund would attempt to replicate, less fees, the performance of the S&P 500 index.

Tip: A fund's expense ratio is the total of its management fees and operational costs expressed as a percentage of the fund's assets, at an annualized rate. For example, an expense ratio of 1.00% means that 1% of the fund's assets are used to cover the fund's expenses. The expenses are charged daily against the value of the fund. For an expense ratio of 0.365%, a charge of 0.001% would be deducted from the fund value each day.

Pros & Cons of Active vs. Passive Funds

Active and passive funds each have their respective benefits but one fund type may work better than the other for some investors. It's wise to learn about the pros and cons of active versus passive funds before you choose to buy, or choose not to buy, a particular type of fund.

Pros of Actively-Managed Funds

• Professional management: Instead of researching, analyzing, selecting, buying, and selling your own investments, you can buy an actively-managed fund and let a professional money manager or management team do this work for you.
• Performance potential: Active fund managers commonly attempt to outperform a broad market index. Although this attempt to outperform the market is associated with higher risk, it does offer shareholders the potential to achieve higher returns compared to an index.

Cons of Actively-Managed Funds

• Higher costs: Actively-managed funds can have expense ratios of 1.00% or higher. Some mutual funds also have sales charges, called loads, that can be 3.00% or higher.
• Manager risk: Active fund managers are susceptible to the same human emotions, such as greed or fear, as other investors and this can lead to poor decisions, such as bad timing of trades, or poor investment selection.
• Tax inefficiency: Active fund managers tend to buy and sell the securities in the portfolio more frequently than passively managed funds. This can lead to more capital gains distributions, which are taxable and passed on to the fund shareholders.

Pros of Passive Funds

• Lower costs: Because passively-managed funds generally have low operational costs, expense ratios are also low. This means that investors keep more of the fund's returns, which can be an advantage over time.
• Tax-efficiency: Passive management also means less buying and selling of securities within the index fund. This translates to fewer capital gains distributions, which are taxable and passed on to fund shareholders.

Cons of Passive Funds

• Lack of flexibility: Passively-managed funds that track an index can only hold the same securities that are in the benchmark index. This means that shareholders of index funds are unlikely to see returns that outperform the index. Usually, returns will be slightly lower than the performance of the index given a fund's expenses.
• Forced selling / forced buying: If investors panic and withdraw their money from passive funds, the fund manager will have to indiscriminately sell portions of all holdings, even those that may appear severely undervalued. The same goes for fund deposits - the passive fund manager will have to buy all constituents of the index, even if some of the stocks look overvalued.
• Weighting methodology: Many index funds have weighting methodologies that cause heavy allocations to few securities, thereby decreasing diversification and increasing volatility from a minority holdings. For example, the S&P 500 is a market cap-weighted, free-float index, which basically means that the stocks with the combination of highest share price and largest number of outstanding shares receive the highest allocation percentage in the fund.

Active vs. Passive Fund Performance

Actively-managed funds can outperform a broad market index, especially over short periods of time. However, primarily due to lower expenses and passive management, an index fund's long-term performance is often higher than the average actively-managed fund within its peer group.

For example the (SPY) has outperforms more than 80% of all large-cap blend category peers, which includes actively-managed funds, over the past 10 years, according to MarketWatch.

Warning: An active management style can introduce more market risk, compared to passively-managed index funds, especially when the manager seeks returns that are higher than a broad market index, such as the S&P 500.

Bottom Line

Generally, investors who want to achieve returns that match a benchmark index, less expenses, may prefer a passively-managed index fund. But investors who seek the possibility of outperforming the stock market, and who don't mind the higher associated market risk, may prefer to buy an actively managed fund.

Deciding whether or not to invest in active funds vs. passive funds is a personal choice and can depend on multiple considerations, such as an investor's unique risk profile and financial goals. Some investors combine active and passive styles within a portfolio, while others may choose neither and invest in a completely different security type.

Important: The information provided here is for educational purposes and does not represent a recommendation to buy or sell a security.

Kent Thune