Active vs. passive investing—what's the difference?

What’s active investing?

Active investing is an investment strategy that requires the investor to be more involved in the investment decision-making process. Active investors watch their investments and periodically buy and sell them to try to outperform a benchmark—in many cases, a stock market index. Mutual funds and exchange-traded funds (ETFs) that use this strategy do the same to try to outperform the market and their peers.

Active investors are regularly buying and selling to take advantage of opportunities to increase the return on their investments over time. This strategy tends to focus more on the short-term result than on the long term. 

If you have the investment knowledge or want to work with an expert, and you’re willing to take on the added risk and cost for the opportunity to potentially achieve greater investment returns, active investing may be a strategy for you to consider.

Advantages

• Greater decision-making flexibility—Active investors buy and sell investments when they think it would be beneficial. This adaptability can be helpful during volatile times when short-term opportunities for making money present themselves. Investors may not be restricted by their benchmark’s makeup, like many passive investors are.
• Increased return potential for the amount of risk—By definition, active investing is a strategy that intends to outperform the market. To outperform your peers, you either make more money than your benchmark or make similar returns, but with less risk of loss.

Disadvantages

• Higher cost potential—Actively managed funds tend to have higher expense ratios—the cost to invest in the fund.
• Tax implications—Sales within the active fund can result in a taxable gain or loss. Profitable sales increase your tax bill, whereas losses during market declines can reduce your taxable income. If you own the fund in a qualified retirement account, such as a 401(k) or individual retirement account (IRA), then you may not have to worry about the tax ramifications of trades made by the fund. Instead, you’ll pay income taxes when you withdraw your pretax savings.¹
• Success can be challenging—It takes great talent (and a bit of luck) for an investor to consistently outperform a market flooded with talented people trying to do the same.

What’s passive investing?

A passive investing strategy, on the other hand, tries to match the performance of a benchmark or target rather than beat it. The S&P 500 Index is an example. When you invest in an S&P 500 Index mutual fund, you’re hoping to get the same return as the S&P 500 Index—not more, not less. The success of a passive investor can be measured by how closely their returns align with their desired benchmark.

Passive investing requires less decision-making and trading than active investing does. You don’t choose how much of one company to invest in within an index—the index defines it for you. For example, if the S&P 500 Index² replaces 10 companies, an S&P 500 Index fund will swap out the same 10 companies.

If you’re more focused on a long-term investing approach and aren’t concerned with trying to capture short-term opportunities, passive investing may be a strategy to consider. 

Advantages

• Ease—The strategy can be simple to execute, understand, and measure. What you invest in is transparent and known by anyone following the same benchmark.
• A company’s success determines returns—Passive investment returns are tied to the performance of the companies in the index over the long term. Active investing success, on the other hand, is credited to the skill of the investor or money manager to make the right trades at the right time.
• Lower cost—Because transaction volume is much less and the strategy may not require exceptional expertise, the cost to passively invest is often less.

Disadvantages

• Missed opportunities—The major downside of a passive strategy is that you may miss out on short-term opportunities to make money. Few investors can capitalize on these instances because they tend to correct themselves quickly, but the ones who do will be active investors.
• Investment limitations—When you passively follow an index such as the S&P 500 Index, you don’t have the opportunity to invest more money than the index does in a specific company.

What are the key differences between these two investing strategies?

You have the option to choose one strategy or you can use both. As you’re deciding how to invest your money, these are some key differences you should understand:

• Desired outcome—What are you trying to accomplish? Active investors attempt to beat their benchmark, while passive investors try to match theirs.
• Cost—Active mutual funds and ETFs tend to cost more than their passive counterparts. The question is whether you expect the added cost to result in greater returns for your investment to make sense. For example, if an active fund has a 2.0% expense ratio and a passive fund has a 0.1% expense ratio, perhaps ask yourself whether you think the active fund is likely to outperform the passive one by at least 1.9% to make it worth the added cost.
• Maintenance and expertise—Passive investors take more of a hands-off strategy, checking in periodically to ensure their investments continue to align with their benchmark. Active investors spend more time researching and looking for opportunities to make money, which most likely requires more transactions, oversight, and expertise.

Choosing a strategy

Active and passive investing strategies both have their benefits and drawbacks. You may find that both have a place in your investment strategy, depending on your unique financial goals. When you’re investing, think about your investment goals, when you want to have access to your money, and how much risk you’re willing to accept. And consider connecting with a financial professional if you’d like ongoing help or a second opinion.

1 Ordinary income taxes are due on withdrawal. Withdrawals before the age of 59½ may be subject to an early distribution penalty of 10%. 2 The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index.