What is the Difference between Active and Passive Investing?

By Financial Advisor Carrie McDonnell

One of the first steps to objectively examine the difference between active and passive investing is to recognize the positive and negative association we often assign to these words. “Active” tends to elicit positive connotations, whereas “passive” holds negative connotations in most contexts. In investing, however, these words are used to describe different investing methods and philosophies, best understood outside of our pre held notions of the words themselves.

What is Active Investing?

Active Investing refers to a strategy in which portfolio managers select stocks or other investments they believe will perform well in the future. Generally speaking, the goal of active managers is to “beat the market,” meaning the selected investments outperform the overall market within a particular index (i.e. S&P 500). If a particular stock selection doesn’t perform as expected, managers will sell that position. As a result, active management involves lots of buying and selling. Mutual funds are, most often, actively managed funds.

What is Passive Investing?

Passive investing refers to a strategy in which investors use broad based index funds exposing the investor to all the companies within a given index (i.e. S&P 500). Rather than trying to beat the market, the goal is to match overall market returns of the index, while minimizing costs associated with investing, such as management and trading costs. Passive investors tend toward a “buy & hold” method in which they hold index funds over a long period of time.

Is Active or Passive Investing Better?

Passive investing has some distinct advantages:

1. Passive index funds typically have significantly lower expense ratios. An expense ratio is the annual fee an investor pays to hold that fund. The Investment Company Institute identifies the average expense ratio of an actively managed equity fund to be 0.68%, compared to only 0.06% for the average passive equity fund.¹
2. Passive funds don’t rely on a portfolio manager to predict or time markets consistently. Instead, a passive index fund, which is made up of all the companies within a given index, is designed to track that index (and the index’s performance) exactly. Statistically, predicting and timing markets is very hard to do over the long term. In fact, over the past 20 years, 90% of domestic equity funds have underperformed the S&P Composite 1500.²
3. Passive funds are more tax efficient. Due to less trading within passive funds, fewer taxes pass through to the investor. In addition, because passive investing strategies rely on investors to hold their funds over longer periods of time, investors have the ability to take advantage of lower tax rates on long-term capital gains when they do sell positions.

1. Investment Company Institute. "ICI Research Perspective, Trends in the Expenses and Fees of Funds, 2021," Page 15.
2. https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2021.pdf