By AJ Smith ·September 01, 2023 · 7 minute read
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Active vs. passive investing generally refers to the two main approaches to structuring mutual fund and exchange-traded fund (ETF) portfolios. Active investing is a strategy where human portfolio managers pick investments they believe will outperform the market — whereas passive investing relies on a formula to mirror the performance of certain market sectors.
Which approach is better, active vs. passive? There seems to be no end to this debate, but there are factors that investors can consider — especially the difference in cost. Because active investing typically requires a team of analysts and investment managers, these funds are more expensive and come with higher expense ratios. Passive funds, which require little or no involvement from live professionals because they track an index, cost less.
Also, there is a body of research demonstrating that indexing typically performs better than active management. When you add in the impact of cost — i.e. active funds having higher fees — this also lowers the average return of many active funds. Following are a few more factors to consider when choosing active vs. passive strategies.
Active vs Passive Investing: Key Differences
The following table recaps the main differences between passive and active strategies.
| Active Funds | Passive Funds |
|---|---|
| Many studies show the vast majority of active strategies underperform the market on average, over time. | Most passive strategies outperform active ones over time. |
| Higher fees can further lower returns. | Lower fees don’t impact returns as much. |
| Human intelligence and skill may capture market upsides. | A passive algorithm captures market returns, which are typically higher on average. |
| Typically not tax efficient. | Typically more tax efficient. |
| Potentially less tied to market volatility. | Tied to market volatility and more vulnerable to market shocks. |
Active Investing Definition
Active investing is a strategy where an investor attempts to beat the market by trading individual stocks, bonds, or other securities.
With active investing, either an individual investor could be the one trading securities in their own portfolios, or portfolio managers of actively managed exchange-traded funds (ETFs) and mutual funds could be the one buying and selling assets to outperform the market or a specific sector.
Active investors and actively-managed funds often trade stocks and securities to profit in the short term. Short-term trading, like day trading or swing trading, can be difficult as it requires the investor to be an expert on the financial markets and the factors impacting stock prices. It also requires the investor to have a good deal of discipline, as short-term stock picking can be a volatile and risky endeavor.
Active Investing Pros and Cons
Active investing is what live portfolio managers do; they analyze and then select investments based on their growth potential. Active strategies have a number of pros and cons to consider when comparing them with passive strategies.
Pros and Cons of Active Investing | |
|---|---|
| Pros | Cons |
| May be fun to follow the market and make your own investment decisions | Difficult to beat the market |
| Can profit in up, down, and sideways markets | Time consuming |
| Can tailor a strategy based on your goals and risk tolerance | Higher fees and commissions |
Pros
• One potential advantage of having a real person crunching numbers and making investment decisions is that they may be able to spot market opportunities and take advantage of them. A computer algorithm is not designed to pivot the way a human can, which might benefit the performance of an actively managed ETF or mutual fund.
• Whereas a passive strategy is designed to follow one market sector index (e.g. the performance of large cap U.S. companies via the S&P 500® index), an active manager can be more creative and is not limited to a single sector.
• The number of actively managed mutual funds in the U.S. stood at about 6,800 as of January 11, 2022 vs. 492 index funds, according to Statista. Given that there are many more active funds than passive funds, investors may be able to select active managers who have the kind of track record they are seeking.
Cons
• The chief downside of active investing is the cost. Hedge funds and private equity managers are one example, charging enormous fees (sometimes 10%, 15%, 20% of returns) for their investing acumen. But even run-of-the-mill actively managed funds, which may charge 1% or 1.5% or even 2% annually, are far higher than the investment fees of most passive funds, where the annual expense ratio might be only a few basis points.
• The majority of active strategies don’t generate higher returns over the long haul. According to the well-known SPIVA (S&P Indices vs. Active) scorecard report of 2022, 95% of U.S. active equity funds underperformed their respective S&P indexes over the last two decades, through 2021. So investors who are willing to pay more for the insight and skill of a live manager may not reap the rewards they seek.
• A professional manager may create more churn in an actively managed fund, which could lead to higher capital gains tax.
Passive Investing Defintion
Passive investing strategy is when an investor buys and holds a mix of assets for an extended period. Many passive investors will invest in passively-managed index funds, which attempt to replicate the performance of a benchmark index. Passive investors are not necessarily trying to beat the market.
Passive Investing Pros and Cons
The term “passive investing” may not have a strong positive connotation, yet the funds that follow an indexing strategy typically do well vs. their active counterparts.
Pros
• Passive strategies are more transparent. Because index funds simply track an index like the S&P 500 or Russell 2000, there’s really no mystery how the constituents in the fund are selected nor the performance of the fund (both match the index).
• As noted above, index funds outperformed 79% of active funds, according to the 2022 SPIVA scorecard.
• Passive strategies are generally much cheaper than active strategies.
• Passive strategies can be more tax efficient as there is generally much less turnover in these funds.
Cons
• Because passive funds use an algorithm to track an existing index, there is no opportunity for a live manager to intervene and make a better or more nimble choice. This could lead to lost opportunities.
• Passive strategies are more vulnerable to market shocks, which can lead to more investment risk.
Which Should You Pick: Active or Passive Investing?
Deciding between active and passive strategies is a highly personal choice. It comes down to whether you believe that the active manager you pick could be among the few hundred who won’t underperform their benchmarks; and that the skill of an active manager is worth paying the higher investment costs these strategies command.
You could also avoid treating the active vs. passive investing debate as a forced dichotomy and select the best funds in either category that suit your goals.
The Takeaway
Active vs. passive investing is an ongoing debate for many investors who can see the advantages and disadvantages of both strategies. Despite the evidence suggesting that passive strategies, which track the performance of an index, tend to outperform human investment managers, the case isn’t closed.
After all, passive investing may be more cost efficient, but it means being tied to a certain market sector — up, down, and sideways. That timing may or may not work in your favor. Active investing costs more, but a professional may be able to seize market opportunities that an indexing algorithm isn’t designed to perceive.
To decide where you stand in regard to active vs. passive investing, it might help to get more experience by opening a brokerage account with SoFi Invest®. As a SoFi investor, you can actively trade stocks online, or invest in actively or passively managed ETFs. You can also buy and sell IPOs and fractional shares. The more experience you get, the more insight you’ll gain into which approach makes the most sense for you. Also, SoFi members have access to complimentary financial advice from professionals, who can answer investing questions. Get started today.
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