What is the difference between active and passive investing?

Active investment management and passive investment management are two investment management styles that measure their success based on performance against that of an index. At the most basic level, these investment management styles can be summarized in this way: 

• Active investments seek to do more than just match the performance of an index — they attempt to, target less investment risk or produce more income than the index.
• Passive investments seek to match the performance of an entire asset class, an asset-class investment style (such as value and growth styles in equities) or a sector by replicating the returns of a specific index.

Typically, passive funds own many of the same securities, and in the same weightings, as their respective indexes. Passive fund managers make no “active” decisions, potentially resulting in less trading, which reduces fund expenses and potential taxable distributions to shareholders. The performance of a passive fund should mirror the index it’s tracking, which means the fund will share the ups and downs of the index. 

In contrast, an active manager will seek to outperform an index by achieving a higher return, taking less risk or combining these two objectives. 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. However, there is no guarantee that an actively managed fund will outperform its index.

The table below summarizes the key benefits and trade-offs of these two investment management styles. (An index is not managed and is unavailable for direct investment.)

Passive vs. Active investing: Benefits and Trade-offs

When should you consider passive management?

If the idea of lower expenses and the potential for better tax efficiency appeals to you, then a passively managed investment may be appropriate. However, with these benefits comes the trade-off of receiving index-like returns – on the upside as well as the downside.

When shouldn’t you consider passive management?

If the thought of participating in all of the downside of the market is unnerving to you, then you may be better served by investing in an actively managed fund that has at least the potential to limit the downside (although this is no guarantee). This potential does come at a higher cost, as the annual expenses of most active funds are generally greater than those of passively managed funds. There are certain areas of the market where we believe passively managed investments are not likely to be as effective as actively managed ones. The reduced liquidity of these areas makes it more difficult for a passively managed portfolio to achieve its objective of providing a return similar to the index.

Which style will outperform?

Many studies* have tried to determine whether the active or passive management style will outperform over time. These studies indicate the following:

• Performance may vary, depending on the asset class.
• Performance may move in cycles – and there will likely be years when even the “best-performing” style may not have positive returns.

In evaluating whether active or passive management outperforms, it’s important to realize that the asset class can often influence the results. For example, some asset classes, such as large-cap equities or investment-grade fixed income, are larger and more established, which might make it harder for an active fund manager to outperform the index. Remember, this doesn’t mean active management doesn’t work in certain asset classes – many active managers outperform regardless of their asset class. It just means it can be more challenging to find managers who might outperform in certain asset classes. On the other hand, in less efficient asset classes – such as small-cap, mid-cap or international equities – active portfolio managers may have a greater opportunity to outperform. Information on these types of companies is likely less widely available, which creates potential opportunity for managers willing to conduct deeper analysis to outperform, although it is certainly not guaranteed. Performance May Move in Cycles – Not only does the outperformance of active or passive management often vary by asset class, it can also vary based on the market environment. For example, when the market has momentum and is showing strong returns, it might be more difficult for actively managed funds to keep up with the index. The reason is that these funds hold different securities from the index, as well as small amounts of cash. However, in weak or declining markets, active managers’ funds might have the potential to hold up better, perhaps by becoming more conservatively positioned when markets become choppy.

We can help

You can work toward achieving your financial goals using either investment management style, or both. Ultimately, your preferences are the most important factors in determining how much of your portfolio is allocated between active and passive investments. Partner with an Edward Jones financial advisor to understand the number of ways to build your portfolio using active and passive investment styles.